EMEA Equity Research Multi-sector September 2010

HSBC Nutshell
A guide to equity sectors

This guide will help you gain a quick, but relatively thorough understanding of 22 equity research sectors and industry groups It will help you to understand the organisation of the sector, the key drivers, indicators and themes, historical context, and suitable valuation approaches It is also an open offer to access HSBC’s expertise in fundamental equity sector research

Co-ordinated by David May, Tim Hammett and Nicholas Peal

Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

EMEA Equity Research Multi-sector September 2010

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Dear Client This HSBC Nutshell: A guide to equity sectors has been compiled by the EMEA Equity Research team at HSBC to help you gain a quick, but thorough understanding of the 22 sectors and industry groups we cover. The guide assumes some basic working knowledge of the world economy, equity markets, financial terminology and ratios, although it is designed to be used by new joiners or people who are looking at industries with which they are not familiar. As one of its business principles, HSBC Group is committed to providing outstanding customer service. HSBC’s Equity Research team reflects this principle in the way we work with you, our clients, on a daily basis. We view working with our clients as a partnership. Within Equity Research, we aim to provide you with ‘best in class, financially robust, independent, insightful, actionable research on a global, regional and local basis’. We are making our resources, knowledge and expertise available to you. Following the publication of this guide, we would like to remind you, our clients, that we are happy to arrange one-on-one or group meetings with our senior analysts to help you build on your sector, industry or stock knowledge – from the nuts and bolts of the industry dynamics through to individual company valuation and recommendation. Please get in touch with your HSBC representative to organise this, if required, or come to me directly. On the front page of each industry section within this guide, you will find the names and contact details of our sector analysts and, where relevant, their specialist sales person/people. If you do not know these analysts and sales people, we would be delighted to set up an initial meeting or call to discuss the HSBC offering and how we can help you. We hope you find this guide useful, and we look forward to working with you or to continue working with you in future. Regards

David May Head of Equity Research, EMEA (Europe/CEEMEA) david.may@hsbcib.com +44 20 7991 6781

While the drivers for each sub-sector are clearly different (air traffic versus threat and geopolitical considerations). integration of electronic systems and satisfactory delivery to the end customer. As a result.  Component suppliers (tier 4 and 5) produce high-volume but relatively low-tech components. They generally bear only some of the risk on the programmes and therefore exhibit less earnings volatility than tier 1 players.  Aerospace – the sub-sector serves the aviation industry and manufactures commercial jets (>100 seat aircraft).com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. partly to diversify their businesses and to mitigate cyclical pressures.  Sub-systems suppliers (tier 3). thereby deriving benefits of economies of scale from common developments. They often display high earnings volatility and do not boast long-term competitive technologies. These are suppliers of major systems and are increasingly transitioning to risk revenue sharing partners on commercial aerospace programmes. they bear most risk for the programme. land-based vehicles. surveillance and radar equipment. The sub-sector also includes the commercial and institutional satellite/related services business. systems and products utilised. These companies are at the forefront of most defence contracts or programmes. with responsibility for designing. with peak-topeak durations in the region of 8-10 years for aerospace OE and 15-17 years for US defence spending. and is not registered/ qualified pursuant to FINRA regulations
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Sector description
The aerospace and defence (A&D) industry sits at the long end of the cyclical landscape.nourse@hsbcib. submarines. The industry structure also drives the industry’s earnings volatility – this is an ‘M’ shaped graph – with earnings volatility being higher for tier 1 (due to programme risk) and tier 4/5 (volume driven) players across the cycle. They are able to extract economies of scale. there are significant commonalities in terms of technological development. execution capabilities and political influence (in the case of defence).
Harry Nourse* Analyst HSBC Bank Plc +44 20 7992 3494 harry. and related armaments.  Defence – the sub-sector serves the armed services and homeland security markets and its activities relate primarily to the design and manufacture of defence equipment including military aircraft.  Tier 2 suppliers. most component suppliers in the industry operate in both sub-sectors. and risks are spread across programmes. The overlap between the sub-sectors is especially significant at the systems and component supplier level. It is also the case that the major aerospace OEMs have significant defence operations. They do not have the product breadth or execution capabilities to compete as prime contractors. Players in the industry can be classified as:  Original equipment manufacturers (OEMs) in aerospace and prime contractors (tier 1) in defence. regional jets and business jets. breadth of products. warships. and components. There are few competitors in this category due to the requirements of scale. manufacturing and assembling the equipment. These have high value added technologies and focus on niches. which makes them more profitable than tier 1 or 2 players.

Defence
It’s all about the money – affordability versus military superiority
Defence spending. as a proportion of GDP. and resulted in most European aerospace names being traded as proxy for the USD/EUR exchange rate. What is unique to aerospace is that the airframers (aircraft manufacturers like Boeing and Airbus) share OE revenues with suppliers. who typically hedge their dollar exposure over a minimum three-year period. engage in fierce product competition and. the commercial OE industry has reduced to a highly competitive duopoly. which generates c35% of its aerospace revenues but more than 80% of its profit from the aftermarket. This trend reversed in 2009-10. to be more profitable through the cycle. This is a particular structural problem for European firms. we anticipate increasing competition from new entrants. and the two firms have largely been competing for share in the wide-body segment. as a result. but the latter get the full benefit of the AM revenues from a large installed base of equipment. thanks to a perceived ‘peace dividend’ and a shift in government priorities. components and systems are arguably in a better position.
Airframers versus suppliers
Both major airframers. be it aircraft. Bombardier (previously a regional jet manufacturer) is entering larger territory with its new 130 seat CSeries. has declined steadily across most of the Western world since the end of the Cold War. As we move into the next decade. Russia with its Superjet 1000 and China with its C919. A good example of this is the engine manufacturer. Currently the narrow-body market is essentially in equilibrium. however. In contrast. therefore. due to a well-functioning oligopoly and lower programme risk and the ability to diversify those risks somewhat across airframers. Safran.
Currency
Sales in the aerospace industry are dollar denominated. The depreciation of the US dollar versus the euro over 2001-08 led to a structural competitive disadvantage for the European manufacturers. engines or systems).
Airframers – from oligopoly to competitive duopoly (and back again?)
Over the past four decades. For example. while costs are in local currency. with Boeing and Airbus vying to capture a bigger share of the market. This leads to relatively low margins on a high fixed cost base. suppliers of engines. For
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. spend significant amounts on R&D and face significant programme execution risk. Airbus and Boeing. Additionally. that segment is a key cash generator for Boeing and Airbus and funds large aircraft development: a risk to demand here could have repercussions for other products. Although most of this additional competition will be in the single-aisle aircraft segment (100-150 seats).EMEA Equity Research Multi-sector September 2010
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Key themes
Aerospace
OE versus aftermarket
Like any capital intensive industry. suppliers also benefit from the differential cyclicality of the two revenue streams – AM revenues tend to decline sooner and recover earlier than OE revenues during a typical cycle. followed by the stream of maintenance and spares expenditure (aftermarket – AM). there are two phases to the end customer’s spend – the purchase of original equipment (OE. in particular EADS (given its cUSD70bn hedgebook). Suppliers tend.

ability to buy new aircraft. We believe that heightened levels of government support are distorting the market at the expense of the health of the secondary aircraft market. and (3) it impacts the economic lives of aircraft. new aircraft orders. However. Changes in traffic growth drive airline profitability and. this is potentially a serious problem in an industry where assets are assumed to have a useful life of about 25 years. exports to regions like Middle East. although expenditure now appears to be peaking.
Yields and fuel prices
Yields (the amount of passenger revenue received for each RPM) and fuel prices affect the industry in three ways: (1) they are a direct input for determining airline profitability and. (2) increasing fuel prices drive replacement demand for more fuel efficient aircraft. As a result. India and Asia ex-China are increasingly becoming focus areas. Yields have been trending lower over time. contract terms and technology transfer requirements can result in complex negotiations (mostly government-to-government). freight demand. where debt financing remains hard to obtain for purchasing aircraft more than 10 years old. this trend reversed after 9/11. CIT and RBS Aviation Capital). the return of aircraft financing markets to normal levels is likely to be a major driver of future demand for aircraft. Air traffic demand is driven by two trends. while flight demand is also affected by consumer confidence (air fares are a form of consumption spending).
Sector drivers
Aerospace
Passenger and freight traffic
Demand for aircraft is largely driven by increases in passenger and freight traffic (measured in revenue passenger/freight mile – RPM). particularly in Europe and the US. we believe affordability and not just superiority of defence equipment will increasingly affect the industry landscape over the coming years. leading to frequent delays. While the US Export-Import Bank and European export credit agencies have stepped in as part of government efforts to protect industrial jobs. for example. As a result. without compromising effectiveness or military superiority. consequently.EMEA Equity Research Multi-sector September 2010
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the US. The current state of government finances.
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. hence. a number of lease firms suffered from their parents’ financial distress (for example ILFC/AIG. which accounts for 46% of total global spend. as the wars in Iraq and Afghanistan wind down. the availability of external financing declined significantly as. as low-cost carriers blossom and increases in fuel prices have resulted in pressure on airlines to replace old aircraft and in a reduction in the economic life of existing models. remain far from comfortable and there is increasing pressure on governments to reduce defence spending (historically an early target for cuts). with the added benefit to contractors of higher margins on export sales. which is particularly important for lessors.
Emerging market opportunity
While Western governments are facing pressures on their finances and defence budgets. some emerging powers are raising budgets.
Availability of finance
During the freezing of the credit markets. tourism and leisure. economic growth has a particular impact on premium passenger traffic (business class).

fastergrowing areas.EMEA Equity Research Multi-sector September 2010
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Defence
Defence spending is typically driven by threats.
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. the need to acquire key technology and. This permits a smoothing of margins over the production period. the actions of competitor nations can be important. Pensions is more a timing issue with the US defence players since pension costs are reimbursed by the DoD as part of the contract billing. The level of R&D capitalisation is important to aerospace investors. the demand from aerospace OEMs to have fewer. and P/FCF multiples. for defence stocks. Similarly. Aircraft production typically requires a long lead-time (a minimum of 18 months) and orders are therefore a keenly observed lead indicator of revenue and earnings growth: they often have more of an effect upon share price performance than actual quarter-to-quarter operational performance. providing the prospect of strong earnings growth as margins expand on higher volumes. which are the most important macroeconomic variable. EV/EBITDA. pension deficit is a major issue for BAE. outdated equipment. which has seen the deficit rise nearly three-fold over the past two years and which has had to make substantial cash contributions to fund the plans. For the defence companies valuations largely track investment account spending and DoD budget growth rates. and new threats can stimulate demand for responsive technology. which are also heavily influenced by hedge rates and other anomalies. in anticipation of increasing earnings. A normalised range for aerospace valuations on forward PE is 8-25x. unit cost accounting methodology provides a better snapshot). Multiple factors have driven industry consolidation– the multi-year decline in defence budgets after the Cold War (1995-98 defence M&A boom in US). war. however. For export sales. rather than expensing them all up front. rising wealth (particularly in countries with abundant natural resources and high levels of economic growth) is a major driver. aerospace valuation multiples tend to peak in the early stages of an up-cycle. There is an ongoing requirement to replace existing. and can attract a higher multiple as a result. the need to achieve critical scale and pool development resources (European consolidation 1999-2003). such as missile defence. Commercial aerospace OEMs have significant operating leverage due to their high fixed costs. although smaller firms may operate in niche.
Valuation: equity characteristics and accounting dilemmas
A&D firms are most commonly valued on forward PE. and politics and ideology. as it can lead to overstatement of EBIT. Pension: On the European side. face the risk of having to fund large pension deficits for the non-defence businesses. but does not provide a particularly helpful measure of current operational profitability (for which the cash-based. more consolidated suppliers capable of sharing development risks and offering bundled products (for example Safran’s proposed purchase of Zodiac). particularly among defence names. Aerospace OEMs like Boeing and Honeywell.
Aerospace and defence: M&A
M&A has been a particular theme in the sector since the 1990s. more recently. Accounting: Boeing uses programme accounting to spread the significant costs of new aircraft development over the life of the programme. Airbus does not use programme accounting and this is one reason for its lower (and more volatile) EBIT margins. the range is rather tighter at 8-18x and is heavily influenced by the direction and trajectory of budgets. As with all cyclical businesses.

They also now face greater market fragmentation and weakening product mix as they enter smaller car segments to cater to changing consumer preferences. Scrappage schemes intended to boost short-term demand during the crisis have also created a strong pull-forward effect that is creating additional medium-term challenges. Germany +49 211 910 3426 niels. light-vehicle sales will continue to be led by emerging markets. particularly in the Western markets. even as the outlook for developed markets remains uncertain. especially for mass-market car makers. Sales in emerging markets are skewed towards small cars and most purchases are from first-time buyers. We believe that globally. premium cars and by replacement demand.fehre@hsbc.de *Employed by a non-US affiliate of HSBC Securities (USA) Inc.schneider@hsbc.
Scrappage incentives led to pre-buying and aggravated pricing risks
Scrappage schemes in the US. Europe and China significantly boosted demand. they have pulled forward future demand.
Horst Schneider* Analyst HSBC Trinkaus & Burkhardt AG. compared with 40% to 50% of the population in Western Europe. Germany had one of the most successful incentive schemes. only 45 out of 1. sales are dominated by higher-priced large. Even though the incentives helped the industry get through the crisis. with typically lower margins. it is not only tracked by financial analysts but also closely watched by the political community. But we do not expect light-vehicle sales in Western Europe and the US to return to the pre-crisis levels of 2007 until after 2014. from which mass-market car makers stand to benefit. Mass-market manufacturers derive most of their sales from smaller and cheaper cars. They have had limited effect on premium cars and light commercial vehicles. as issues of overcapacities in Europe are left unaddressed. the highly cyclical nature of the sector caused new-car sales. However. they face challenges from stricter CO2 regulations globally. Premium car makers. For example. which require high investments to develop low-emission technologies.de Niels Fehre* Analyst HSBC Trinkaus & Burkhardt AG. supporting around 12m jobs (2m directly) and contributing significantly to the EU’s GDP with a net trade of cEUR40bn a year. which in turn is the key profitability driver. particularly the BRIC economies. In China. for example. This enabled 20% y-o-y growth in 2009. rich features and brand equity enable them to command higher transaction prices. and are exposed to a larger extent to cyclical demand. Coupled with government austerity measures in Europe and weakening US macro data.500 on new cars if a car nine years or older was scrapped in return. At the onset of the economic crisis. to collapse as consumer confidence plunged. They rely on high production to push asset turnover. it offered a discount of EUR2. Germany +49 211 910 3285 horst. we expect unit sales growth in all regions. Beyond an uncertain 2011. typically derive higher margins. we believe that represents further risk for 2011 and beyond. but now after its expiry.EMEA Equity Research Multi-sector September 2010
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Sector description
The European automotive sector is very important to the European economy. In developed markets. Added value from advanced technology. with exposure to larger-car and SUV segments. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Emerging-market growth compensating for weaker developed markets
Low car penetration and rising disposable incomes should lead to higher organic growth in emerging markets. they are challenged by low capacity utilisation and constant pricing pressures. Besides being exposed to the fragmented small-car segment. Consequently.
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. causing steep declines after they expired.000 people own a car. The sector can broadly be classified into mass market car makers and premium car makers. Developments in the auto sector influence and indicate the mood of the economy. particularly for small cars.

However. Standardisation helps to reduce the R&D cost per vehicle and to realise purchasing synergies from shared components. since the large companies can combine more units on a single platform. Modularisation also gives large car makers such as Volkswagen an advantage over smaller competitors such as Renault and PSA.5m cars a year and more than 1m cars per platform. the government is pushing car makers to consolidate and has also brought in mechanisms to keep tabs on capacity expansions. only temporary plant shutdowns. such as Renault and Nissan or Volkswagen and Suzuki. resulting in the Fiat-Chrysler alliance and many discontinued brands. We believe that only by consolidation can car makers raise production volumes high enough to increase asset turnover and alleviate pricing pressures. technology limitations and product costs mean such technologies are likely to dilute earnings before they can be expected to pay dividends.
Size matters: Capacity utilisation and restructuring
Low capacity utilisation and insufficient scale is a particular concern for mass-market car makers. gearboxes. To reduce per-unit costs and leverage the benefits of scale. in our view. transferring some manufacturing capacities to low-cost Eastern European sites and doing some minor structural cost savings. the European auto industry is in dire need of consolidation.EMEA Equity Research Multi-sector September 2010
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we expect sales to decline c24% y-o-y in 2010 and to reach 2007 levels only by 2012e. In 2008 and 2009. even putting their old business model at risk and forcing them to enter smaller car segments. CO2-based taxation in developed markets and higher oil prices have driven investments in alternative power-train and low-emission technologies. We forecast electric-car penetration rates to reach 7. plug-ins and pure electric vehicles. It reduces the number of architectures even though the average number of units per model series may decline. The next frontier for the industry is developing alternative power trains. Margins face additional risks from consumers accustomed to the incentives now expecting discounts from car dealers. Significant R&D is currently devoted to improving the efficiency of existing gasoline engines.5% of global light-vehicle sales by 2020e. engines and axles that are not technological or brand differentiators. are only strategic in nature. green technology requires significant R&D investment by both car makers and component suppliers. restructuring was mostly confined to short-time work. Premium car makers are particularly burdened by stricter emission regulations. From alternate fuels to hybrids. Others. car makers now increasingly rely on alliances and joint ventures to share platforms with other manufacturers. where high production volume is the prime earnings driver. Fiat’s CEO defines this level as more than 5. political ramifications and government loans make meaningful consolidation difficult to achieve in the near future in Europe. Plagued by overcapacity.
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. Significant cost savings can be achieved by standardising components such as air-conditioning systems. involve equity cross holdings. Some alliances.
Reducing CO2 emissions
Stricter emission standards. one of the most fragmented markets. like PSA and Mitsubishi or Daimler and BMW. Other areas for exploring synergies involve joint procurement.
Modular architectures and platform sharing
Increasing standardisation by greater use of modular platforms is a key strategy. downsizing engines and emission reduction. US companies underwent intensive restructuring. By contrast. Challenges involving charging infrastructure. In China. product development and technology sharing.

especially in the mass market segment. geographies. In general. In a highly competitive industry.
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. monthly sales by car makers. raw material prices and interest rates
Currencies: Since companies cannot always produce their cars where they sell them. which is exposing all car makers to additional mix challenges. disposable incomes and GDP. The sector is extremely data-intensive. largely because small cars have a lower price and therefore smaller earnings margins. the issue is back on the table. new product launches and competition. and inventory at dealer networks. unemployment. Premium car makers tend to be more profitable than mass-market car makers. we use data from our partner consultancy IHS GlobalInsight. car makers are obliged to constantly invest in developing new model ranges. underscoring the need for more economies of scale and standardisation. European and Japanese car makers are exposed to currency risks.
Product mix and new model momentum
For car makers.and C-segment cars. New models and their consequent product-mix and volume effects are vital earnings drivers as well. Scrappage incentives in Europe improved pricing for small cars because of the huge demand. and their vital role in determining top-line and margin forecasts. and for other key markets like Brazil. incentives data in Europe and the US. higher CO2 taxation and fuel prices and increasing emergingmarket exposure have helped small cars gain market share. which in turn depends on macroeconomic factors such as: consumer confidence. only recent and profitable model ranges help counter competitive pressures and boost margins. and vehicle segments as well as platforms. we are able to make sales and production forecasts by models. and being
predominantly an export-driven business. the recent sovereign debt crisis has reversed this trend briefly. Pricing is influenced by a combination of factors. US SAAR data. B. Volumes are thus primary margin drivers for the sector. but with their expiry in 2010. Some of the closely tracked statistics are: monthly sales numbers from ACEA for Europe. car makers must spread fixed costs across as many units as possible. Appreciating the complex nature of factors influencing volumes. price elasticity is fairly high. and German companies have been burdened with a stronger euro. which offers a competitive edge to our research. Aggressive volume targets in a contracting market and efforts to increase capacity utilisation will leave car makers fighting on the pricing front in 2010. it is very relevant whether unit sales are dominated by large or small cars. residual value of used cars. including segment/product mix shifts. For the mass-market segment. With that. which makes it difficult to pass on price increases to customers. Although Japanese car makers benefited from a weak JPY in the past. Premium car makers derive higher revenue per unit by selling larger sedans and SUVs than the mass-market car makers who predominantly sell smaller A-. Car makers can only hope to counter this trend by selling cars with more feature-rich technology packages.
Pricing
Pricing is another closely monitored element of car makers’ margins. which boosts margins per car.
Exogenous factors: FX. China and Japan.EMEA Equity Research Multi-sector September 2010
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Sector drivers
Volumes and macro data
As a capital-intensive business with rising costs for new model and technology development.

Headline operating profits are reported by most companies by business segments. Typically. unemployment. In addition. the individual car maker’s credit rating and its credit default swap rates. they probably affect demand growth in emerging markets to a larger extent. However. financial services. while unemployment rates are more of a lagging indicator. GDP growth and development of disposable income. which will not be found in the financials of their industrial peers. The activities of the financial services business are akin to those of banks: they accept deposits and undertake leasing and financing of cars and dealerships in addition to issuing securitised debt. Having benefited from lower steel and other commodity prices in 2009. EV/EBIT and EV/EBITDA.
Valuation: equity characteristics and accounting dilemmas
The market has a good degree of visibility on performance.
Leading indicators: Consumer confidence
Sales and production forecasts for the auto sector depends on the overall view for consumer spending. precious metals and rubber. core industrial operations and financial services. higher raw material prices are expected in H2 2010 from contract re-pricing with steel makers. Those conditions are determined by overall risk-free interest rates. the activities of auto companies are organised into two distinct segments. Other commodities include aluminium.
Interest rates: Financial services operations at auto makers are a capital-intensive business. which in turn depends on a wide range of factors. Refinancing conditions determine the net interest income and are one of the key profitability drivers. plastics. and have segments engaged in diverse business activities – trucks.
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. We believe consumer confidence is the best indicator for short-term demand developments. these companies hold significant financial stakes in other companies. which only provide sales and revenue data quarterly and other details in their half-yearly report. Disposableincome changes have a limited effect on car sales in developed markets. motorcycles and logistics – with varied exposure to cyclicality. Companies in the sector trade on traditional multiples. EV/sales. Monthly unit sales figures also provide visibility on top-line development in the sector.EMEA Equity Research Multi-sector September 2010
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Raw material prices: Steel is the most important input factor for car production and makes up around
60% of the total car weight on average. which are 12-month-forward price/earnings ratios. among them consumer sentiment. as all companies in the sector provide detailed disclosures by business segments on a quarterly basis except for the French companies. traditional multiples are of limited help in comparing auto sector stocks with their peers in the wider industrial sector. any change
in refinancing costs can have a substantial impact on group P&L.

the asset and liabilities structure is likely to remain at the forefront of management focus over the next few years. The banking sector remains a highly regulated sector globally. leading to valuation gains/losses. with multiple regulatory bodies keeping close watch. arrangement fees.EMEA Equity Research Multi-sector September 2010
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Sector description
The bank sector functions as an intermediary between sources of capital (investors and depositors) and users of capital (individuals. The various lines of business for banks are classified below:  Net interest income. usually in a crisis. BNP Paribas. banks hold securities to manage their liquidity. In providing this function banks take on three major risks: credit risk (the risk that a borrower will not repay a loan). Deutsche Bank) CIBM activities account for a large part of their profits.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. that assets cannot be liquidated quickly enough to cover any short-term funding deficiency). on the economy. Also. Fears on sovereign risk: The stress test of European banks by the Committee of European Banking Supervisors (CEBS) proved to be a non-event as some of the assumptions it used were considered too
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. if any. interest rate risk (changes in the yield curve may change funding costs and asset yields) and liquidity risk (the risk. for example. but those detailed below are likely to remain for some time. There have also been efforts to evolve global standards in banking via the Basel norms. although in some cases (Societe Generale. With a few exceptions (Credit Suisse. Banks need to mark to market their securities. In light of the recent financial crisis there has been an increased focus on regulating banking activities and minimising the impact of future banking failures. developed by the Bank for International Settlements.  Trading income: Banks derive trading income by transacting in securities/derivatives/forex.  Fee and commission income. overdraft fees. typically calculated as the ratio of loans to deposits. guarantees as well as asset management and insurance. is the key indicator: a ratio of 100% or less indicates that the bank can count on a balanced structure with an optimum balance between loans and deposits. as well as more specialised institutions focusing on a more limited business segments such as corporate and investment banking activities (CIBM). corporations and governments). UBS) the majority of European banks are universal banks. with a consequent impact on funding costs.digrandi@hsbcib. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Key themes have changed rapidly in the past two years. includes account fees. risks or themes in bank management. defined as the difference between the interest rate earned on assets and the interest rate paid on liabilities: typically 65%+ of revenues. payments.
Funding issues. such as perceived country risk. typically 25% of revenues. This relates to both internal (pertinent to a specific bank) and external factors.
Carlo Digrandi* Co-Global Sector Head HSBC Bank Plc +44 20 7991 6843 carlo. The liquidity ratio. mostly known as universal banks. In our view. The bank sector includes institutions providing a comprehensive product offering to their clients. Trading income is typically 10% of total revenue. Recent events have proven that the funding issue remains one of the key issues. A higher ratio would imply a need to procure liquidity in the wholesale market.

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. In our view these are extremely important drivers. as banks normally tend to spread their financing according to the different rate levels along the curve – for example making the spread the differential between short rates (lending or borrowing) and long rates (borrowing or lending). A second important element relates to market conditions and the interdependence of the banking system. as lending demand is normally positively correlated to expanding economic conditions and vice versa. thereby forcing banks to increase LLPs and write-offs. Among others. following the subprime crisis. envisaged only conservative credit losses and used headline Tier I instead of core Tier I. the role of regulators in the banking sector has increased dramatically and it is expected to increase even more in the future. The recent liquidity crisis has shown the extreme importance of this factor and the weight that market conditions (rates. As a result this is proving to be a key driver for the sector. as they are mostly exogenous and affect the sector overall.EMEA Equity Research Multi-sector September 2010
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mild. again. we would summarise the main. Asset quality and loan loss provisions (LLPs): Non-performing loans (NPLs) tend to increase in periods of economic difficulty.
Sector drivers
Banks’ earnings are very closely correlated to economic growth in the countries where they operate: volume growth is a function of GDP growth. for example. The steepness of the yield curve is also a key factor. Increased regulation (Basel III and related issues). lowered margins and changed the sector’s revenue base. nevertheless. In several European countries NPLs and unemployment growth are closely correlated. correlated to economic conditions. In the past two years. however. Hence banks could be considered a proxy for GDP growth. Deposit growth is more a function of market yield. making it very difficult to differentiate between individual stocks. it failed to consider sovereign default. this will remain an issue until the final proposal is approved. while growth in loan loss provisions is linked to unemployment. Other than GDP. Most would argue that this should be lower due to lower leverage and declining margin. alternative investment opportunities and gearing ratios but is. Although spreads are controlled to a large extent by banks. It seems. Interest rates: Cost of money is based on a spread banks apply to interest rates. which may limit the impact on the sector. New compliance rules have simultaneously increased costs. fundamental sector drivers as follows: Lending and deposit volumes. thereby making banks less profitable overall. Sector profitability: The introduction of tougher regulation has raised some doubts about sector profitability over the next cycle. obliging banks to raise additional funds to meet new rules. the role of the central banks) can have on banking stocks. the level of interest rate is given by the market. For obvious reasons banks tend to prosper in a high interest rate environment (when the spreads between assets and liabilities tend to be wider) and vice versa. interbank lending. The introduction of Basel III (currently still in discussion) is expected to heavily affect capital requirements. These are mainly related to GDP. Empirical analysis also suggests that LLPs and GDP growth are relatively well correlated. that Basel III proposals will be subject to several changes.

leading investors to adopt a more cautious approach. acquisitions. This method makes it possible to isolate the corporate centre. Instead. which are adjusted for extraordinary and one-off items such as disposals. valuation methodologies are based on tangible book values and ROEs rather than reported figures. This is not a new valuation methodology. it should be trading at or close to its book value (market volatility and equity risk premium are captured in the cost of equity). although book value multiples dominate in periods of low earnings/recession. On the other hand. thereby assessing the real profitability of the business. Spanish banks have large generic reserves and LLPs are treated differently from a tax perspective in the different European countries. Most recently. BBVA and RBS) a sum-of-the-parts method is often used. Santander. for example. we use core earnings figures. we do not adjust earnings for all these and other issues. In the case of large complex banks (such as Credit Suisse. as it is simply the correlation between book value and profitability (ROE). UBS. Intesasanpaolo. PBV for the divisional businesses of the bank. in some cases. As a result. In the majority of cases. write-offs and large trading losses. based on the theory that where a company’s return is similar to its cost of equity. Over the past five years the sector has benefited from a consolidation process.
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. Unicredit. as the process would be too cumbersome and much data is unavailable. This has also boosted goodwill. analysts have been using a warranted equity value (WEV) model. differ from one country to another. Tier 1 calculations. Accounting issues abound among banks. there is no means of assessing the cross-subsidy among divisions as the corporate centre is also used as a financing fulcrum by most banks. This is just a combination of the above criteria and is based on the application of ‘exit PEs’ and. especially in some European countries.EMEA Equity Research Multi-sector September 2010
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Valuation: equity characteristics and accounting dilemmas
Banking stocks are generally valued on PE multiples.

SABMiller and Heineken. Coca-Cola Co. bottle. export and market a wide variety of wine and liquor brands. and PepsiCo own and market nonalcoholic beverages. sell and distribute non-alcoholic and alcoholic products. like A-B InBev. the beverage sector is as a defensive industry which is typically more resilient during challenging economic and market conditions because it can offer affordable products to consumers.  Revive the carbonated soft drink category – this is a longer-term solution. which should support volume growth and cater to health and wellness trends.c. be proactive with new-product introductions. sell and distribute soft drinks to retailers in designated regions. including soft drinks. beer. and in the fourth quarter of 2010. Pepsi Bottling Group and PepsiAmericas. Some are regional. import. creating an industry where scale matters. They are best known globally for their Coca-Cola and Pepsi trademark brands. which is easier said than done. in some of which they hold an equity interest.com
Key themes
Over the past couple of years.
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Lauren Torres Analyst HSBC Securities (USA) Inc +1 212 525 6972 lauren. market.hsbc. Recently. On a positive note. is scheduled to acquire the North American bottling business from its largest bottler. and PepsiCo have a global network of bottling partners. increasing costs of ingredients. and a competitive price environment.torres@us. sports drinks and enhanced water – this is a near-term solution.  Capitalise on energy drinks. but should be key to jump-start volume and profit growth.  Brewers produce. CocaCola Co. We believe beverage companies need to revive struggling categories while focusing on potentially higher-growth categories.  Soft drink concentrate companies such as Coca-Cola Co. but realising opportunities to offset these increases is necessary to operate more efficiently. others. distribute and sell beer. market.hsbc.EMEA Equity Research Multi-sector September 2010
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Sector description
The beverage sector includes companies that develop. packaging and energy. tea and sports drink brands.  Soft drink bottlers produce.  Wine and spirits companies manufacture.
Soft drinks
We believe that the key concerns/themes for the soft drink industry are:  Cost of doing business is going up – particularly sweetener (sugar and/or high fructose corn syrup) and oil costs. They tend to be more regional than the brewers but have been active in acquisitions and have broadened their geographic and brand exposure. Coca-Cola Enterprises. Price points vary widely from super-premium to mainstream to value brands. wine and spirits. juice. Both companies manufacture and sell concentrate/syrup to their bottling partners. but they also have a diverse portfolio of water.watson@us. produce. are global. the beverage industry has experienced its fair share of challenges: a deteriorating consumer environment as a result of the economic downturn. PepsiCo acquired its two largest bottlers.com James Watson Analyst HSBC Securities (USA) Inc +1 212 525 4905 james. Brewers have undergone a fair amount of consolidation over the past several years. rationalise costs and expand globally.

 Focus on and grow international operations – go where the growth is.
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.  Currency devaluation – depending on the company’s reporting currency.  Continued cost pressure – more expensive ingredients (barley.
Beer
We believe that the key concerns/themes for the beer industry are:  Weakening economic conditions – a pullback in consumer spending. malt and hops) and packaging (aluminium and glass) have been an issue that may not be resolved in the near future.  Step up media and new product launches – to remain competitive. over mainstream brands.  Reasons for shift in preference – variety: catering to changing consumer tastes and needs (different brands. beverage volume tends to closely track GDP growth or decline. reinvigorate domestic operations but take advantage of opportunities overseas. and the beer industry has become more competitive as consolidation continues (SABMiller was surpassed as the largest brewer by volume by Anheuser-Busch InBev).  Intended marketing spend may not be enough – brewers may need to re-invest more in their brands through greater and more effective marketing spend. since fixed-rate contracts are in place. brand image: desire for affordable luxuries.EMEA Equity Research Multi-sector September 2010
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 Capture growth in high-margin immediate consumption channel (mix) – drive revenue-per-case growth with improvements in product and package mix.  Changing “share of throat” – independent from weakening macro-economic trends.  Competitive/consolidating industry – many beverage companies are global. But they also trade down to lower-priced and lower-margin products when disposable income is reduced. such as light beers. Part of the industry’s revival could depend on improved beer brand equity. there has been a growing preference for premium wine and spirits and imported/craft beer. particularly on higher-margin premium brands and on-premise purchases. health-conscious: looking for lower calories or carbohydrates. white wine and clear spirits. package sizes and price points). consumers tend to trade up to higher-priced and higher-margin products that are aspirational and considered to be affordable luxuries.  Aggressive price promotions – the pricing environment has been favourable. often brought about by high unemployment. a stronger US dollar may hurt results because of higher local procurement costs and a translation hit to earnings. but price promotions could return to protect share and boost volume. more needs to be invested in product promotion and development.
Wine and spirits
We believe that the key concerns/themes for the wine and spirits industries are:  Trading up vs trading down – depending on the market environment.

 Resilience of beverage sales during economic downturns – these categories offer consumers variety at attractive price points. we believe it is important to consider a company’s product and geographic portfolio and its ability to manage costs while still investing in growth opportunities.  Continue to selectively invest – despite continued market and industry pressures. which is the responsibility of the brand owner and distributors. particularly younger consumers with more disposable income
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. they have a more stable.EMEA Equity Research Multi-sector September 2010
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availability: good product placement and marketing. spirits and imported or craft beers. streamlining organisation or leveraging global scale.  Geographic diversification – global companies have an advantage over smaller competitors. profitable markets but also look to expand into emerging markets  Capitalise on favourable demographics. while running an efficient production and distribution system  Manage through a tough cost environment (rising energy and raw-material costs)
Global players should be better positioned to capture future growth
 Scale and scope matter in the beverage industry  Expect to see more acquisitions and production/sales/distribution agreements among companies  Realise growth in core.
Conclusions
Shift in consumer preferences:
 Beverage consumers want a quality product with a strong brand image  A preference for premium wine. particularly those not overly exposed to any one market. companies need to take advantage of investment opportunities to emerge as stronger competitors when healthier conditions return. which could deliver significant cost savings.
Sector drivers
In difficult market conditions. stronger brand equity and the strongest distribution system  Right balance of volume and pricing growth. through realising bottling plant or brewery efficiencies. availability and healthier beverages (low calorie/low or no carbohydrates)
Winning in a competitive environment
 Necessary to have strong brands. more so with non-alcoholic than with alcoholic brands. particularly in a stable or strengthening economic environment  Also a need for variety. developed market presence in addition to good growth potential and emerging market presence. That allows beverage companies to achieve volume and pricing growth despite a pullback in overall spending.  Continued cost management/realisation of synergies – beverage companies have tightened their belts.

it is important to sift through reported and organic (comparable) results to understand the company’s true growth rates. since the companies tend to be more capital/debtintensive. We would also highlight that bottling stocks tend to be more volatile than the concentrate companies. EV/EBITDA is a better metric. below historical averages in the high-teens.’s share price began to fall after reaching historical highs in the late 1990s. CocaCola Co. also below historical averages closer to 9-10x. For the brewers. and PepsiCo. rather than fundamentals. when looking at a company’s results. Currently. On EV/EBITDA. In the alcoholic beverage industry. market and consumer environments. Lastly. with faster-growing companies such as Brazilian brewer Ambev at the high-end of the range. Brewers face the same pressures. or market speculation of a potential change in the industry. They are more exposed to higher ingredient. PE is the most widely-used valuation metric. packaging and energy costs. the concentrate companies are trading at 14-16x 2011e consensus earnings. in a rather narrow range. For the bottling stocks. as there have often been a number of below-the-line items with wildly skewed earnings (EPS).EMEA Equity Research Multi-sector September 2010
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Valuation: equity characteristics and accounting dilemmas
Beverage companies tend to trade on forward-looking price/earnings ratios and on EV/EBITDA. The graph “historical PE valuation of the non-alcoholic and alcoholic beverage industry” shows beverage companies have traded. There are disadvantages to using PE for brewers. There are some outliers which take into consideration mergers. meaning EV/EBITDA could be a better metric for historical and peer group comparison. the bottlers are trading at 7-8x 2011e consensus EBITDA estimates. and typically reflect the economic. as there has been a fair amount of M&A activity in the sector. on average. but typically are more diversified and can manage this more effectively. acquisitions. 7-11x 2011e consensus EBITDA is the current range.
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. For Coca-Cola Co. certain stocks have traded more on takeout speculation. In the non-alcoholic beverage industry. as growth rates began to slow and relationships with its bottling partners became disjointed.

Costs may also be reduced by managing the number of stock-keeping units (SKUs).
FM and hygiene offer a range of diverse services to the premises of their clients. The distributors sub-sector has a very
diverse client exposure. Another cost-reduction strategy is the use of private labels or own brands.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. larger and better-stocked centres – which can reduce staff costs as well as freeing up property.com Alex Magni* Analyst HSBC Bank Plc +44 20 7991 3508 alex. This process has been under way for some time and is now largely complete. One option is to move towards using fewer. pest control and reception services. focusing on positions requiring professional skills. BPO and consulting firms. there are consulting firms providing engineering and design services to their clients. (b) whether business revenues are affected by the tax receipt cycle.EMEA Equity Research Multi-sector September 2010
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Sector description
Business services can be generally classified as enablers or intermediaries. and re-sell to a client base. the companies must demonstrate more defensive growth than is in the price. They have an arsenal of efficiency measures to offset pricing and volume pressures.lloyd@hsbcib.
Distributors purchase items. a distributor can focus its purchasing power on fewer suppliers and reduce input costs.
BPO/consulting firms have a broad variety of business models. However. or indeed whether they respond differently to different cycles. and is not registered/ qualified pursuant to FINRA regulations
outsourcing firms. prison
management. alarm monitoring and security assessment. In order for valuations to be attractive. At one end of the spectrum we have pure
Matthew Lloyd* Analyst HSBC Bank Plc +44 20 7991 6799 matthew.
Distributors
Distributors effectively suffer or benefit from the cyclicality of their clients. among others. where companies broadly work on renting a variety of
assets. The industry is fragmented and services are either offered directly to the client or through a facilities management contractor. by and large. geographical exposure. and professional staffing business.magni@hsbcib. This enables a distributor to buy large quantities of a product from a supplier and offer them to clients at a
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. This will broadly depend upon three questions: (a) whether non-public expenditure is non-cyclical. ranging from builders and grocery stores to janitors and research scientists.
Staffing includes firms which provide permanent and temporary workforce to organisations and is
primarily categorised as general staffing business. The different rental companies are distinguished from one another by factors such as asset type. and at the other end.
Rental services is a heterogeneous sub-sector. have less cyclical cash flow streams than much of the rest of the business services sector. The latter is more common in the UK and the US. and (c) how margins are affected by the cycle. capital structure and economic sensitivity.
Security services provide a wide array of security services such as manned guarding. the most pertinent question is the extent to which individual companies are less cyclical. By focusing on a smaller list of SKUs. It includes businesses such as staffing.
Key themes
BPO/consulting
Outsourcing companies. store them. the former in Europe. focusing on positions requiring general skills. to work-wear and linen. ranging from facilities
management.com Rajesh Kumar* Analyst HSBC Bank Plc +44 20 7991 1629 rajesh4kumar@hsbcib. although there are doubtless additional options. distributors. which work on a cost arbitrage model.

enhancing their gross margins. and has historically demonstrated margin pressure late in the cycle. during initial phases there is frequently a spurt of catch-up hiring in the labour market. temp tends to recover earlier and more quickly than perm since permanent staff are expensive and carry more employment risks. Indeed. and geographical diversity. for example. alarms and monitoring services. the nature of this gearing is more nuanced than it first appears. Consolidation remains a long and ongoing structural trend in these highly fragmented markets. offering bundled services of access control. and rental companies’ ROIC profiles are likely to approximate their cost of capital across a cycle. Rental companies are also notorious for their gearing. Evidence that operational gearing is a later-cycle phenomenon is powerful since wage growth happens in the later stages. The effect was significant in the blue-collar markets and the UK IT market in 2001-04. However.EMEA Equity Research Multi-sector September 2010
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discounted rate. and in the early 1990s. guarding is a reasonably mature market and outsourced service appears to be a stable proportion of the market. The capital base in a rental business is not fixed and can be expanded or shrunk relatively quickly in response to changing end-markets. but during economic recovery they grow before white-collar temps. In the early stages of a recovery. the rental business model permits an unusual degree of flexibility in controlling cash flows. if distributors engage in cost-cutting measures in a downturn that cut capacity. The distribution business lends itself to acquisitions because of the fragmented nature of the market. Security firms nowadays provide integrated technology services. Another increasing trend among distributors is to move towards web-based sales. These services are normally a mark-up to labour charges. However. there has been emergent pricing pressure on certain key sections of the market. In developed markets.
Rental companies
Despite the cyclical nature of its end-markets. When an early spurt in perm subsides.
Security firms
The business is widely perceived as being late cyclical. leading to exaggerated profit and share price behaviour at turning points in an economic cycle. In previous recoveries. gross profit growth becomes subdued as temp constrains the value per sale and the gross margins. this can reduce the medium-term upside during recovery.
Staffing
Staffing largely centres on the volume and price of services offered and the ability of companies to reduce cost without damaging client relationships. the effect particularly bedevilled the profit recovery during the early part of this decade. growth in overheads tends to be correlated more to volumes.
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. The key distinction between staffers stems from the temp: perm mix. However. web sales are not only higher margin but also result in better inventory management and higher cash conversion. This is because the upward pressure to raise wages clashes with clients’ desire to reduce costs. Advances in technology have extended the scope of security to electronic surveillance and monitoring. Bluecollar temps are largely low-margin business with limited operational gearing. However. Investors should be cautious of businesses that cut headcount more aggressively than peers as staffing remains a relationship business and the elimination of too many client-facing costs can materially reduce long-term growth during and following recovery. Typically.

Rental companies Size is a key driver for rental companies given low entry barriers and service differentiation. In a deflationary period.
Inflationary or deflationary environment: Distributors are beneficiaries of a mildly inflationary
environment as there is a lag of few weeks or months between their purchase and sale of a product. the inverse is true. These clients exhibit a degree of cyclicality. giving them holding period gains. give negotiation power and help to achieve economies
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. fiscal deficit and tax receipt cycles.EMEA Equity Research Multi-sector September 2010
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FM and hygiene
The FM and hygiene businesses provide a host of diverse services and the businesses face different markets and challenges. Large. the key driver of margin is mix: the more complex the contract. Wage rate mix: Broadly speaking. some of the companies in the sector have complex margin drivers. The more cyclical the client base.
Sector drivers
Outsourcing Government spending: Companies in this sub-sector have varying exposure to government contracts
and are directly exposed to local and central government spending. Although contracted revenues are indexed to inflation. Government tax receipt cycles play a key role. they held up in the latest downturn. Spot business generally attracts higher margins while longer-term contracts usually have lower margins. A fall in the average wage rate reduces the value of sales more than a fall in volume and also affects the gross margins or conversion of gross margin into operating profit.
Contract mix: Margins of BPO and consultancy companies are largely determined by the contract and are
applicable for long periods. ranging from builders and grocery
stores to janitors and research scientists. The wages of candidates are a product of the scarcity of their skills at any point in time. Historically. gross margins may nudge up. sales rise faster than volumes. a lower wage rate implies a lower gross margin. Spot-contract mix is one of the key determinant of margins. driven by government revenue. Generally they are able to pass on most of the inflationary price rise to their clients. whereas no such cost exists for a permanent placement. The effect is magnified lower down the P&L because much of the SG&A is volume related. This same scarcity tends to drive the gross margin a staffing agency can charge for sourcing candidates. Given the diversity of business. the more margin variation is possible. and distributors effectively suffer or benefit from the cyclicality of their clients. however.
Distributors Cyclicality of client: Distributors have a diverse client exposure. A decline in the perm mix has a magnified impact on margins.
diversified fleets help broaden the customer base. spot sales have been c8-10% of sales at the peak of the cycle and have disappeared in recessions. Ceteris paribus.
Staffing
Temp/perm mix: Temporary staffing is a lower-margin business than permanent placement as the wages of a temporary worker form part of the agents’ sales and cost of goods sold. the more cyclical a distributor’s business. and growth in the companies exposed to the public sector has weakened in the wake of a fall in government tax receipts in previous cycles. in a period of ‘accepted inflation’. and SG&A costs grow with volume.

which cannot be passed on to customers in a recession. It is also important to keep track of changes in regulation and the resulting impact on accounts. For companies where pension liability is a major concern. For distributors. OECD leading indicators and ISM. to ensure that they convey the same economic content. inventory-to-sales ratio. operating profit. comparing staffing companies on EV/EBITDA may be meaningful as these are not capex-intensive businesses.
Valuation: equity characteristics and accounting dilemmas
Companies in this sector trade on traditional metrics. alarms man-hours. (3) cost of delivery (sales. Long-run returns are driven by: (1) rental rates. If a client wishes to clean its facilities less frequently or engages less security. man hours are among the key indicators. The best leading indicator for labour markets remains US temp numbers. one needs to be careful when comparing multiples across companies. then sales and also margins are likely to come under some degree of pressure. book-to-bill ratio. lead indicators of the clients are important for analysing distributors. Although the PE ratio is the most widely used multiple. distribution and services). purchasing. key leading indicators are industry shipments. historical multiples and a DCF-based valuation. Most such services are cyclical and can be tracked through employment numbers. for example. grocery man-hours and janitorial man-hours for FM and hygiene. and (4) the cost of funds. Leading indicators: The broad lead indicators for business services sector include the TCB leading indicator. Also.
Other businesses sector
The other businesses sector covers a host of largely blue-collar general services. Each of the sub sectors has a different lead indicator specific to the dynamics of the business. analysts prefer using EV/EBITA (adjusted for the pension). maintenance. Some analysts prefer a blended valuation obtained via relative valuation. The key differences stem from the classification of amortisation arising from acquisition intangibles. the share of profit from associates and exceptionals. EV/EBITDA (mainly for rental companies). (2) utilisation. For instance. As with building distributors.EMEA Equity Research Multi-sector September 2010
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of scale. housing price and inventory and plumber man-hours. Job vacancies in the US. the key leading indicators are private housing starts. EBIT and EBITA. The US employment market has historically been a leading indicator for the rest of the world. uniform supply man-hours for security firms and pest control man-hours. For the rest of the blue-collar general services. EV/sales. FCF yield and FCF to EV. use of DCF-based valuations should be viewed with caution – particularly during periods of economic uncertainty and poor earnings visibility. a recent change in regulation requiring a reclassification of French business tax from COGS to tax has boosted gross margins for staffing companies without affecting EPS/operating cash flow. Gross margin risk can frequently come from rising wage rates. Hence. Discrepancies and/or changes arising from accounting adjustments need to be handled carefully when comparing historical trends or different companies. but a few exceptions do exist. for example. These tend to be contract-backed but volume-dependent. For example. eg security man-hours. other multiples often considered for valuation are EV/EBITA. The core economics of the security business is the mark-up over the cost of labour. the UK and Europe are the best lead indicator for UK staffing agencies. Scale helps in all four.
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.
Accounting notes
Companies within the sector report their profits in a dissimilar fashion despite sharing nomenclature categorised as trading profit. However.

which extends through technologies. Put simply.com Colin Gibson* Analyst HSBC Bank Plc +44 20 7991 6592 colin. demand focuses more on replacement and MRO. In developed markets. dominated by the ‘E3’ of China.gibson@hsbcib. higher-value-added product offering. Accordingly. as companies typically sweat assets far more than private individuals do. The leading companies within each sector have traditionally exploited this power and have faced relatively few pricing pressures. Diverse markets are inevitably niche markets. aftersales or ‘MRO’ (maintenance. What differentiates capital goods from consumer goods is the level of utilisation.
Matt Williams* Analyst HSBC Bank Plc +44 20 7991 6750 matt. This often has positive effects on margin expansion. These barriers to entry do not just refer to manufacturing efficiency but also include input costs and perhaps most importantly. where a combination of political pressure for energy efficiency. and consequently barriers to entry are high.
Providing a ‘solution’
The ‘solution’ has become a buzzword within the capital goods sector. demand has focused on the rapid build-out of infrastructure and manufacturing capacity. ultimately. India and Brazil. could overtake DMs in total dollar value during or around 2013. there have been instances of price-fixing and collusion on occasion.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. no JD Power). and is not registered/ qualified pursuant to FINRA regulations
Key themes
Emerging versus developed markets
In emerging markets. relatively cosy oligopolies. demand for more modern energy technology is seen in DMs. Often. aftersales provision. and their competitive environment. EMs need energy right now. if these growth rates are maintained. EMs grew rapidly over the past decade and. and represents a desired step away from just supplying a tangible product. with relatively little in the way of good third-party data (no Gartner. while the service element adds balance sheet lightness to the equation. the rump of the market is highly fragmented and occupied by many smaller unlisted companies. Much of the job of capital goods research is thus the development of an understanding of the specific markets a supplier is active in.williams@hsbcib.
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. Buyers typically expect reliable and geographically extended MRO networks. more efficient energy technology. The classic example is the bundling together of a product with a service component (aftermarket care. rewarding the incumbent leaders. Within capital goods. or energy efficiency consulting) in order to provide a more comprehensive. profitability levels and. and continue to be. and power technology companies have benefited. valuation multiples. which new entrants struggle to provide. many sub-sectors have historically been. whose profitability and financial health are hard to ascertain. There are normally positive economies of scale to be had.j. applications and customer groups and shows up in growth rates. At the same time. DMs need clean energy. likely growth rates. repair and overhaul) accounts for a far larger proportion of the total market opportunity than it typically would in consumer markets.
It’s all about the energy
A key capital goods theme has been the provision of energy to a rapidly industrialising EM space. increasing oil prices and environmentalism have led to demand for cleaner.EMEA Equity Research Multi-sector September 2010
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Sector description
The distinguishing characteristic of the capital goods sector is a profound heterogeneity.

or being closed altogether. many capital goods companies make substantial profits on the aftermarket component: commercial truck makers provide vehicle servicing. exiting noncore operations in order to concentrate on more profitable. This outsourcing has allowed for greater flexibility by capital goods companies. where specific components are in short supply. is linked to the broader economic cycle. say. while elevator companies maintain the lifts after they come off warranty. the sale of the new equipment is done at paper-thin margins (or even as a loss-leader).’ companies have become much more actively involved in the ‘make or buy’ decision.
Capex versus opex
Despite this primary focus on capex.
New equipment versus aftermarket
In addition. with plants in Western Europe being converted to assembly rather than actual manufacture. and which inefficiencies will begin to creep back in.
Key components: assembly versus manufacture
In the first decade of the new millennium. Outsourcing of components increased – not limited to just ‘simple’ components – and the proportion of ‘assembly’ business increased in turn.EMEA Equity Research Multi-sector September 2010
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Restructuring effects and operational leverage
Post-Lehman. Mining equipment companies. there is also a distinction between a customer’s capital expenditure and its operational expenditure – capital goods firms vary in their exposure to either. the financing environment for such projects must also be borne in mind.
Sector drivers
Capex cycle
Capital goods companies’ earnings are directly related to the capital expenditure activities of their end customers. value-added activities. For those companies that did target fixed costs effectively. the sector underwent widespread restructuring. With this refocusing on ‘core activities. and the likelihood that these capex investments will generate positive-NPV projects. In such circumstances. for example. Customer activity. Some companies put staff on shorter working contracts (four-day weeks not being uncommon). the primary target being the fatter service margins. the continued development of the installed service base (and competition in the third-party aftermarket sector) is key to maintaining these defensive revenue characteristics. In some circumstances. the challenge now is to see what proportion of cost savings are permanent. In some instances.
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. margins have expanded significantly. for example) and can maintain revenues even at low points in the capex cycle. both private and public sector (the latter currently exposed to austerity budgets). now that survival appears guaranteed. margin expansion driven by operational leverage has been impressive. are often more exposed to customer opex than true capex (they sell more replacement drill heads than complete new drills. but has also led to some occasions of supply chain problems. existing progressions to relocate manufacturing jobs to low-cost countries were accelerated. in turn. unfocused conglomerates began a wave of divestments. Businesses that had become commoditised and consequently faced greater competition. EM manufacturers (such as cable manufacturing or semi-conductors) were spun out (either via IPO or trade sale or LBO). from. while others closed factories and reduced staffing levels. As such. As sales have recovered for some companies. aimed at targeting the cost side and preserving margins in the face of declining sales.

EMEA Equity Research Multi-sector September 2010

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Another significant distinction can be made in the product destination. Assa Abloy, for example, stresses that two-thirds of its products are sold to refit and refurbishment markets, and not new-build, reducing the overall cyclicality of the business. At low points in the capex cycle, firms are universally keen to emphasise these more defensive aspects of their product portfolio.

Input costs
Capital goods companies are big buyers of raw materials, including (but not limited to) industrial metals such as iron, steel, nickel and copper, plus plastics and other miscellaneous item. Policies vary, but as a general rule, the sector does not engage in overly long-term hedging, and consequently has an exposure to rising input costs. That said, rising raw material prices usually correlate with rising end-user demand, especially in EM. In addition, the leading companies enjoy strong pricing power, and can often pass on price increases to end-customers.

Mix effects
Mix, namely the relative profitability of different products within the offering, also affects profitability. For example, in some sub-sectors, the products required by EM are less sophisticated than those in DM, and consequently margins are lower. In contrast, certain more complex high-end solutions sold to DM offer higher profit margins.

Intra-sector specialisation, de-leveraging, industry consolidation
Although some companies do operate across the many specialised sectors that make up capital goods, the majority stick to one particular operational axis, such as electrical equipment. The value of broader economies of scale achieved by operating across the segments is not viewed as significant. Consequently, industry consolidation exists primarily within a sector, eg Schneider Electric operates in both low- and medium-voltage electrical. Some companies do operate in more than one sub-sector – for example, United Technologies is present in three separate aspects of building technology, and Siemens is present in power technology and lighting (and various other segments) – but this normally represents a step into the diversified industrials segment, as opposed to any attempt to cross-sell. The sector has seen its fair share of M&A activity, which has largely been concentrated, with acquisition of smaller fry by the larger players within each sub-sector as opposed to mega-mergers of equals. M&A has recently focused on the acquisition of technology from smaller growth firms and geographical expansion, most notably within EM. At the same time, some of the conglomerate-style companies have sought to turn over their portfolio in order to maintain a presence at the sweetest spot of the sector, and divestments and spin-offs have not been uncommon, often via IPO, and often when that business has become overly commoditised (examples would include Philips’ sales of its semi-conductors business, or ABB’s exit of the cables business). The natural consequence of such activity is that those involved on both sides of the coin have purchased attractive high-PE businesses while selling commoditised or highly cyclical low-PE businesses. During lulls in M&A activity, some firms have collected significant cash on the balance sheet, which has led to intense speculation as to likely M&A targets or the means by which cash would be returned to shareholders. Since companies have focused activities, reduced cyclicality, reduced debt and increased balance sheet cash, one could be forgiven for considering the likelihood of private equity activity within the sector. This

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EMEA Equity Research Multi-sector September 2010

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is a valid argument, although the size of the targets is a complicating factor, as is a possible perception that most of the fat has already been trimmed.

Leading indicators
The activities of capital goods companies are summarised at the macro level by the measurement of gross fixed capital formation, ie the value quantity of the fixed assets ordered and subsequently manufactured. Some (larger) products lend themselves better to the publication of order book statistics than others. There is a huge array of data covering the sector, including such diverse data series as EMEA Regional Gas & Steam Turbine Orders, Chinese Fixed Asset Investment in the Oil & Gas Sector, and Australian mining capex to name but three.

Valuation: equity characteristics and accounting dilemmas
Industrial companies trade on traditional metrics, namely forward-looking PE ratios, EV/EBITDA, and to a lesser extent, price/book. At the peak of the cycle, the rolling one-year-forward PE reached 19x, while it troughed at 8x, immediately post the Lehman collapse. A normalised range for the sector is around 12-18x. Companies can also be valued using traditional discounted cash flow analysis, applying a weighted average cost of capital (WACC) to forecasts in order to arrive at a theoretical fair value. Alternatively, one can employ a ‘reverse DCF,’ a method which avoids the use of backward-looking data (such as beta). Instead one determines an appropriate growth rate for cash flow returns on invested capital (CROIC) and then, using the current valuation as the PV, solves for the market-assessed cost of capital (MACC). This MACC can then be compared with the sector average (is company X rich or cheap to the sector?) or versus its own history (is company X at a historical peak or trough?). Intra-sector free floats vary considerably. In some cases, the reduced liquidity makes it unaffordably risky for hedge funds to short, and thus stocks enjoy artificial support beyond that of the fundamental quality of operating activities and earnings prospects. Some stocks are especially popular with local retail investors, and Bloomberg free float estimates can overstate. Different companies elect to report operating profits in different ways, making comparisons complicated. Some report their headline number as EBITA, some as EBITDA and others are content to publish a simple EBIT number. Legrand, for example, chooses to use ‘maintainable adjusted EBITA.’ There is, unfortunately, no solution other than going through the notes to the accounts to determine exactly how that company’s unique brand of profit has been decided. There are also wildly varying levels of disclosure within the companies’ own operating segments: some companies do not split out profitability by either business unit or by geography, and in some cases, the suspicion remains that cross-divisional subsidies mask the true profitability picture. In addition, some firms publish their order intake as part of their quarterly reporting, while others decline to do so.

EMEA and Americas HSBC Bank Plc +44 20 7991 6892 geoff. We expect M&A to continue to play a major role in the sector. upgrading of infrastructure and a growing middle class. There are several chemical conglomerates encompassing all of the sub-sectors.high capital intensity .to maintain constant margins need to innovate product offering .tend to be price-takers . which has resulted in topline growth trailing that of other industrial sectors.
Key themes
Emerging versus developed market economic growth
Historically the industry’s end-markets have focused on the developed world. and is not registered/ qualified pursuant to FINRA regulations
Lanxess Rhodia SABIC Solvay
. However. with the growth of manufacturing.high R&D requirement particularly in crop protection and seeds .highly concentrated markets.fragmented end-market and few leading players .low capital intensity . agrochemicals.com Sebstian Satz* Analyst HSBC Bank Plc +44 20 7991 6894 sebastian.high capital intensity in fertilisers so low cost base is key
Sector has undergone a strong transformation
Ten years ago there were 17 large-cap chemicals companies. The remaining companies have also undergone major transformations as they have generally exited any commodity chemicals in which they did not have a leading position.high capital intensity . The industry is made up of a series of global oligopolies reflecting the fragmented nature of the endmarkets.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc.satz@hsbcib.haire@hsbcib. a
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. UCB and Bayer) or have been acquired by competitors or private equity. industrial gases.customer service is key Agrochemicals Israel Chemicals K+S MA Industries Monsanto
Source: HSBC
Geoff Haire* Head of Chemicals Europe.EMEA Equity Research Multi-sector September 2010
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Sector description
The Chemical sector.generally exposed to consumer rather than industrial demand . nine companies have either exited chemicals (for example. There are four sub-sectors – commodities.need to keep cost base low . speciality. However.cyclical. emerging markets are of increasing importance to the Chemicals sector.highly dependent on crop demand and farmer economics . exposed to economy and supply demand cycle
Syngenta Uralkali Yara
. comprises a wide range of companies serving various end-markets. Since then. However. customer relationships and technology. up to 15 years . particularly in Europe and the US. The barriers to entry are capital cost. big 4 players represent approximately 75% of the market .long-term contracts. The sector average exposure to emerging markets is 27% of sales.
Summary of sub-sector characteristics Sub-sector Commodities __________ Companies ___________ Characteristics Arkema BASF Braskem Dow Chemical DuPont Specialities Akzo Nobel Croda DSM Givaudan Industrial Gases Air Liquide Air Products Linde Praxair Johnson Matthey Symrise Umicore . companies are generally price-takers as customers have more bargaining power (specialities and industrial gases) or prices are set with respect to the macro environment (commodities and agrochemicals).

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number of companies in the European sector already have a sizeable position in emerging markets. currently Solvay and DSM are active buyers and BASF has just acquired Cognis for EUR3. the term speciality has been misused by companies and should only apply to products that can sustain high margins and growth such as crop protection.
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. speciality chemical prices tend to be driven by the value the chemical adds to the customer’s products/processes. its vinyls chemical businesses). Raw material costs are more than 65% of the overall price. Brenntag and Christian Hansen. There have been three types of activity: consolidation within the sector (for example Akzo Nobel acquiring ICI).
Substitution
The threat of external substitution to the chemical industry is limited but internal substitution is a constant threat. There are two broad categories of chemicals – commodity and specialities. Customers can easily switch suppliers. including Rhodia (45% of sales). history has shown that speciality chemicals can easily become commodities in the absence of innovation.
Commoditisation
One of the inevitabilities in the chemical industry is commoditisation.1bn. private equity activity (the formation of Ineos. such as biotechnology and nano-materials. Givaudan (35%). which could result in new lower-cost or better-performing products. in the first half of 2010 two companies. Commodities chemicals prices tend to be set by public markets and are heavily correlated with input costs and supply/demand balances. However. had already come back to the public market. or new low-cost manufacturing processes. and Access Industries creating LyondellBasell from two acquisitions and. Syngenta (33%) and Lanxess (33%). Raw material costs represent less than 40% of the price. Products are defined by chemical entities and the barriers to entry are low if you have unlimited capital. and Total spinning out Arkema. Symrise (35%). In contrast. We also expect private equity to bring chemical companies back to the market as the economy and equity markets recover. for example polyethylene being substituted for polypropylene in packaging. Currently there are many companies investigating new technologies. fragrances and some engineering polymers. It is not easy for customers to switch suppliers as this can involve changing manufacturing processes. Internal substitution is driven by other producers looking for new end-markets as well as customers looking for lower priced materials. Apollo acquiring LyondellBasell). and oil and healthcare companies spinning off their chemical businesses (for example Novartis and Astra Zeneca forming Syngenta. engineering polymers and fine chemicals. There are few competitors in this category.
M&A
Over the past ten years we have seen significant M&A in the sector. end-market changes or new entrants chasing higher margins. There are many competitors in this category. We have seen examples of this in plastic additives. catalysts. Linde (35%). later. We expect M&A to continue in the sector as balance sheets are healthy. In our opinion.

as these represent more than half of the price of a product (as much as 65%). In 2001 Europe and North America accounted for 54% of the world’s ethylene production. There are at least two reasons for this. approximately 50% of any cost savings are given back within five years of them being achieved. We believe average volume growth rates tend to be 1. management need to reduce costs or invest in new high-growth businesses. which is both a positive and a negative. industrial gases. Commodity companies are more exposed to input costs than speciality producers.3x IP. However. commodity chemicals volumes have grown at 2. with catalysts.5x GDP. Commodity players generally only have pricing power when input costs are rising and even then they may not be able to recover all of the higher costs. as a rule of thumb.
Restructuring
This is constant activity within the industry as companies look for ways to reduce the fixed cost base of below-par businesses or integrate new acquisitions. In times of fast-rising fossil fuel prices. agrochemical and industrial gas producers will have varying degrees of pricing power as they are providing a service that is essential to their customers’ products and processes. if we include energy. Chinese and Asian industrial growth has become an important driver of earnings and share price performance. the movement in real long-term pricing (ie after inflation) is negative. engineering polymers and electronics growing at over 2x GDP. The positive aspects come from governments and regulators around the world being focused on
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. but paper and textile chemicals volumes at less than GDP. However. attracted by low gas prices. As commodity producers strive to reduce the cost base. as customers are reluctant to take higher prices. the majority of the industry has struggled to pass on price increases quickly. are fossil-fuel based. so at the peak of the pricing cycle margins may already be falling.0x GDP and 1. Volume growth rates across sub-sectors vary dramatically. Over the last 20 years there has been a high correlation between the performance of the European and US chemical sectors and IP in the developed world. In the shorter term.4-2. by the end of 2010 we expect this to have fallen to approximately 40% and the Middle East to account for 19% by 2010 compared to 9% in 2001.8x IP and industrial gases at 2. so growth can only come from cost reduction.4x IP. speciality chemical.3x global GDP and 1. as product portfolios become commoditised. resulting in margin compression for a few quarters. therefore if volume is growth just above global GDP. The other sub-sectors are less exposed to input costs and potentially have more pricing power. Secondly.4x global GDP and 0.EMEA Equity Research Multi-sector September 2010
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Sector drivers
Macro economics and pricing power
Top-line growth in the sector is driven by GDP and industrial production (IP). It is worth noting that the industrial gas players tend to have prices linked to inflation and the cost of energy for the large plants (tonnage) that they operate for customers. specialty chemicals volumes at 1. Over the last ten years. First.
Input costs
We estimate that 65% of the sector’s input costs.
Environment
One of the key long-term secular drivers in the sector is the environment. they have shifted a large amount of production to the Middle East. top-line growth is at best flat.

The “holy grail” is mass production of zero emission vehicles (ZEVs).
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. a move toward biofuels and the amount of arable land is restricted. through protecting plants.
Valuation: equity characteristics and accounting dilemmas
The market is focused on short-terms earnings growth. The drawback to this is that the companies have changed so much over the last ten years that comparing current with historical multiples is of little value. asset turn (sales/IC). Johnson Matthey and Umicore. In contrast. which can be achieved with either fuel cells or batteries. A DCF captures the future value of investments that that have been made already. profit margin and weighted cost of capital. Solvay. there is a need for agrochemical companies (crop protection and fertiliser) to develop products that can increase yields. Although the technology currently exists for this. Therefore. The negative aspect of the environmental issue is regulations requiring the chemical industry to reduce emissions in Europe. populations rise. Moreover.to 18-month forward earnings basis. The main beneficiaries of tighter emissions have been the catalyst producers – BASF. as well as using sum-of-the-parts (SOTP) for conglomerate companies. Authorisation and Restriction of Chemicals) and carbon emission limits to which they have to conform or be taxed on any emissions above the limits. We expect the focus on vehicle emissions to continue as the EU and North America progressively reduce limits and the emerging markets (Brazil. This is important for highly capital-intensive companies. ie eating more meat.
Feed the world
There is a clear need for more food as the developing world becomes richer and more urbanised. Evaluation. as 40% of the world’s harvestable crops are destroyed by weeds. as the key drivers of a DCF are growth in invested capital (IC). It tends to value companies on a 12.EMEA Equity Research Multi-sector September 2010
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reducing vehicle emissions. the engineering polymer producers (DSM. mainly using PE and EV/EBITDA multiples. BASF and DuPont) also benefit as vehicle producers substitute plastics for metals. and does not capture the future value of those companies that have invested heavily either in R&D or acquisitions. a return on capital metric (ROIC or CROCI) or a discounted cash flow (DCF) takes into account the return of all the capital that has been invested in the company historically. This includes REACH (Registration. insects and fungi. it is not commercially attractive and a new fuel/recharging infrastructure would need to be established. China and India) start to tackle the problem of emissions.

robins@hsbc.clover@hsbcib. A third is the diversity of sub-sectors. The sector includes energy-saving technologies to reduce energy consumption in buildings. which emit less carbon than fossil-fuel vehicles. Clean Energy HSBC Bank Plc +44 20 7991 6741 robert.EMEA Equity Research Multi-sector September 2010
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Sector description
Clean energy comprises a wide range of technologies intended to address climate change and energy security by shifting from a high-carbon to a low-carbon economy. which relies on the use of light-emitting diodes. energy efficiency for building. transport and disposal of waste. trains and trams – are considered part of transport efficiency as well. and efficient water and waste technologies. control systems. but challenges remain to the competitiveness of clean energy companies. wind power. Another is the need for innovation in low-carbonenergy technologies. water conservation and recycling and advanced water-treatment technologies. more efficient lighting. industries and transport.
Robert Clover* Global Sector Head. Those technologies include low-carbon energy. unlike fossil fuels. which tends to have been formulated in an effort both to reduce greenhousegas emissions and to provide secure sources of energy. Climate Change Centre of Excellence HSBC Bank Plc +44 20 7991 6778 nick. Some support-services companies provide environmental consulting. It uses nuclear energy and renewable-energy sources that. and smart systems that control and manage power consumption in buildings. One is regulatory uncertainty. industry and transport.com Nick Robins* Head. are not depleted over time. instrumentation. which also falls under this theme. Building efficiency includes: improved building materials that control the transfer of heat into and out of buildings. A shift from road to rail transport and use of electric and hybrid-electric vehicles. geothermal and hydropower. Lowcarbon-intensive fuels like biodiesel and ethanol are also included.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. since growth is driven to a large extent by regulation. Transport efficiency includes technologies that reduce the carbon emitted by conventional transport. falls under transport efficiency. smart grids and energy-control and power-management systems. Industrial efficiency and multi-theme efficiency encompasses products or processes to conserve energy in industrial sectors. Waste management comprises mainly the collection. Low-carbon power producers like utilities are also included in the sector. Mass transit – buses. These include process automation. energy-efficient chillers and directional lighting. The water sector includes companies providing efficient water supply. Low-carbon energy includes power generation using no fuel or less fuel than conventional powergeneration technologies and producing no or fewer pollutants than conventional technologies. Energy efficiency involves replacing existing technologies and processes with new ones that provide equivalent or better service but consume less energy. which requires enough investment by governments and the private sector to offset the economic advantage of conventional technologies. solar power. and is not registered/ qualified pursuant to FINRA regulations
Key challenges
Clean energy is a growing industry in both developed and developing markets. It also includes energy-storage technologies such as batteries and alternative energy storage technologies such as fuel cells which can store energy through storing reactants like compressed hydrogen. such as biomass and biofuels. Especially in
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. as are companies that supply efficient-engineering systems or parts that are supplied to cleaner forms of transport. compact fluorescent lamps and sensors.

the US and Japan.
Energy efficiency: theme for next decade
A transition to a low-carbon economy will be driven by climate-change regulation and concern over energy security. It has since started to look up again. demand is expected to be more for replacement of existing lowcarbon energy production.
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. the EU. notably renewable and nuclear energy.
Key themes
Emerging versus developed markets
The developed world has been the mainstay of the low-carbon economy over the past decade. So far. whose profitability and financial health is hard to determine. The second is taking energy out of growth. unlisted companies. primarily because it has a larger base of installed nuclear and renewable generation capacity and more focus on installation of energy efficient technologies. Brazil. we estimate the share of the former will decline from 60% in 2009 to 53% in 2020. They define two complementary policy trends. that is likely to see a shift in demand to the developed world for new technologies. so the availability of financing is critical. while the share of the latter will grow from 25% to 34%. The transition to a low-carbon economy will create winners and losers by having major. Investment in the industrialised world is likely to continue to dominate over the next decade. new investment in clean energy saw a significant dip. resulting in a highly fragmented market occupied by a large number of smaller. Its goals for low-carbon energy and energy efficiency mean its demand for clean energy technologies is likely to outstrip that of its developingmarket peers. As credit dried up after the collapse of Lehman Brothers in September 2008. they cover a wide range of technologies. especially in the US. We believe that will change in the coming decade as governments implement policies to deliver ‘negative cost’ improvements in building and industrial efficiency and push for a shift in transport to hybrid and electric vehicles. Saving costs through energy efficiency should make the economics compelling for expansionary plus replacement cycle spending as global economic growth improves. but different. value implications across sectors. China and India. oil and gas. Along with regulatory uncertainty.4trn by 2020. and few developers generate enough free cash flow to sustain their own investment needs. industry and transport. Wind and solar projects in the developed world are typically funded 20% by equity and 80% by project finance. and providing incentives for low-carbon sources. by promoting energy efficiency in buildings. the lowcarbon economy has been dominated by changes in energy supply. In the developed world. In emerging markets. the spotlight will be on China.
Credit crisis and its impact
The renewable-energy industry is young. and the three leading emerging markets. but the share of emerging markets will increase. We estimate the energy-efficiency market will outgrow other clean-technology sectors and may grow from around USD320bn in 2009 to between USD722bn and USD1. One is taking carbon out of energy supply by curbing emission from fossil fuels. Looking at the three key players from the industrialised world. notably coal.EMEA Equity Research Multi-sector September 2010
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energy efficiency.

however.
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. according to the International Energy Agency. DCF is preferred to relative multiple valuation methodology given the difficulties involved in multiple analysis for a relatively young sector with poor profitability. prompting them to opt for renewable. based on peer group multiples. inexhaustible energy sources. Wind-farm developers are usually valued using sum-of-the-parts-based (SOTP) valuation methodology in combination with DCF. are also used. The valuation generally takes into consideration the different underlying regulatory frameworks in the various countries in which the company is present. because of its potential and its low cost. The other advantage of DCF is that it is an absolute valuation methodology. Many factors come into play to encourage a business to invest in low-greenhouse-gas energy. A combination of DCF and SOTP. for example. Energy efficiency is probably the preferred approach. But population growth and increasing industrialisation is likely to drive demand for energy up by more than 50% by 2030.EMEA Equity Research Multi-sector September 2010
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The response so far has come mainly in various cap and trade schemes and through international regulations like the Kyoto Protocol. and the investment normally flows to where the highest and quickest returns can be made. Achieving energy security will become increasingly important for many countries as demand rises and fossil fuel reserves are depleted. In the European Union. or an economic value-added (EVA) approach. The high. the Emission Trading System aims to reduce emissions 20% from 1990 levels by 2020. volatile energy prices of 2008 were a warning for many countries of their growing vulnerability.
Valuation: equity characteristics and accounting dilemmas
For wind-energy companies – primarily wind turbine manufacturers and component suppliers – DCF is the main valuation tool. is the way low-carbon strategies can stimulate industrial innovation. In Japan and France. for example. More important for a growing number of decision-makers. For solar stocks DCF is also primarily used as a valuation tool. based on book value growth and ROE. early innovation has resulted in widespread deployment of low-carbon technologies such as high-efficiency coal power plants and nuclear power making them less carbon-intensive than other countries.

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Notes
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and is not registered/qualified pursuant to FINRA regulations
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.davis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc.EMEA Equity Research Multi-sector September 2010
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Construction and Building Materials
Construction and Building Materials team
John Fraser-Andrews* Head of European Construction and Building Materials HSBC Bank Plc +44 20 7991 6732 john.fraser-andrews@hsbcib.com Jeff Davis* Analyst HSBC Bank Plc +44 20 7991 6837
jeffrey1.

wallboard.com Jeff Davis* Analyst HSBC Bank Plc +44 20 7991 6837 jeffrey1.  Typically. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Urbanisation cycle underpins decades of robust EM construction growth
Our statistical regression analysis suggests that cement consumption is determined by real GDP per capita growth. and the light-side materials manufacturers. The other 20% – called social units – are built for and sold to government bodies at low margins. up to a saturation point.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc.davis@hsbcib. often as a necessary concession for residential planning approval from the local planning authority (called Section 106 agreements). Residential developers combine land (which must have residential planning approval in the UK) and building materials to construct and sell houses. The heavy-side majors have about two-thirds of their cement capacity in fast-growing emerging markets that are benefiting from a structural expansion in infrastructure. Housebuilders and contractors are the main customers for building materials companies. as well as the foundations stage of residential and non-residential buildings.
John Fraser-Andrews* Head of European Construction and Building Materials HSBC Bank Plc +44 20 7991 6732 john. Urbanisation further perpetuates population growth. which enhances absolute GDP and growth thereof. Holcim. GDP per capita of around USD1. insulation. after which the cement-demand-to-real-GDP multiplier falls below unity. engineering and construction and facilities management. as shown in the sector organisation chart. tiles. The companies can be divided into the heavyside materials majors.000 to USD3.  This saturation point is at around GDP per capita of USD13. for example.  This urbanisation cycle (see chart “The cement intensive urbanisation cycle” below) supports cement consumption/construction output growth in excess of real GDP growth.fraserandrews@hsbcib. Saint Gobain and CRH. underpinning cement-intensive mass infrastructure investment and real estate development. aggregates ready-mix concrete and asphalt) are consumed by infrastructure projects like road expansion and utilities infrastructure. Heavy-side materials (cement. when infrastructure and the housing stock have largely been provided. Light-side producers are predominantly exposed to weak and fragmented construction end-markets in debt-laden developed economies. pipe and glass) are used predominantly in above-ground-level building construction. including project design. as illustrated in the first graph above.
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. Light-side materials (concrete products. bricks. The UK is comfortably the most consolidated market in Europe.EMEA Equity Research Multi-sector September 2010
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Sector description
The construction sector is a vertical chain of sub-sectors that begins with the building materials companies.000 triggers population growth and urbanisation from a low base. Cemex and Heidelberg Cement. where approximately 35% of production is undertaken by the seven listed builders. The contractors deliver services essential to the creation and care of infrastructure and non-residential buildings assets.000 (the top of the hump in the graph “Cement consumption per capita versus GDP per capita” on the previous page). Lafarge.
Building materials
Building materials companies produce the materials used to build homes (by residential developers) and commercial real estate and infrastructure (by contractors). About 80% of UK new-build homes are sold speculatively to individuals.

The US government has increased infrastructure spending. barriers to entry and low import penetration. such as high concentration. Cement is generally supplied on a local market basis by a limited number of producers. which implies weak demand for building materials.  We expect UK housebuilders to suffer sluggish volume (and top-line growth) for several years. which are generally fragmented and highly competitive. Unsurprisingly. Weak loan growth is likely to weigh on residential and non-residential construction because:  Most home-buyers need mortgage support. Cement imports restricted to markets near shipping lanes. producers compete on innovation.
Source: HSBC
Finished goods Medium. we expect the availability of finance to remain constrained for at least the next two years because:  Many western economies are suffering from record household indebtedness.
Consequences Lower competition in cement markets versus competitive markets for building materials. banks are unwilling to substantially increase the availability of cheap finance to households and businesses in this fragile economic climate.
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.
Fiscal austerity set to drive large cuts in European infrastructure construction
European governments are suffering from record indebtedness and unsustainable budget deficits. Market concentration High. high unemployment. Medium. determined by high capital investment barrier to entry.
Heavy-side producers offer a more defensive investment opportunity
Comparison of heavy-side and light-side Cement Substitutability Very weak. relying on reserve currency status to maintain a high budget deficit and indebtedness. weak earnings growth and stretched long-term housing affordability. that underpins more disciplined pricing than in light-side markets. Transcontinental transport determined by weight and build. We forecast public construction spending will decline by 25% from the end of 2009 to 2013e in Spain and Ireland. Building products more susceptible to overseas competition. economies of scale here led to consolidation but transportability ensures competition. We expect European infrastructure budgets to suffer from public spending cuts as governments give priority to spending on front-line services. than in fragmented finished goods markets. European contractors face a challenging market in the medium term and we expect demand for building materials from the European infrastructure end market to remain weak until 2013e.  The banking industry continues to deleverage due to funding constraints and more stringent regulation. limited to mixing cementitious substitutes by cement producer to reduce cost batch. leading to higher pricing discipline. so we expect housing demand to remain weak for some time. The policy response has been austerity programmes to reduce fiscal deficits over the next four to five years.  Private developers rely heavily on finance to fund their working capital requirements and for financial leverage to amplify their returns on capital.EMEA Equity Research Multi-sector September 2010
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High household indebtedness and constrained finance availability to weigh on developed market construction growth for several years
In developed economies.
The table above shows the heavy-side materials market benefits from several characteristics. and by 10% to 14% in other European countries. recognised that uneconomic to travel by road for more than 300km. Transportability Low.

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. The only key accounting issues are the plant depreciation rates of building materials producers and the profit-recognition policies of contractors. retail sales and manufacturing output as proxies for commercial real estate space demand.EMEA Equity Research Multi-sector September 2010
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Sector drivers
Construction and building materials leading indicators
Affordability and mortgage availability are key long-term leading indicators for residential construction. We use governments’ infrastructure budgets to determine future public construction wherever possible. This discount exists despite our expectation of a strong earnings rebound to 2013 for the cement majors on robust emerging-market growth (approximately two-thirds of company cement capacities) and an operationally geared US construction recovery from 2011. the builders’ landbanks are decomposed into tranches by age and region and then mark the book value of each land tranche to today’s market value (we also exclude goodwill). High housing demand drives growth in building-permit applications and housing starts. A combination of high space demand and low vacancy usually leads to rising rents. Vacancy rates show the demand/supply balance in commercial real estate markets. therefore. The heavy-side building materials companies currently trade at EV/EBITDA and PE multiples of 4. We track office employment.
Valuation: equity characteristics and accounting dilemmas
The building materials companies and contractors trade on traditional earnings metrics. The mark-to-market adjustments restore the landbanks to full margin and returns on capital. the builders should trade at slight premiums to these adjusted TNAVs to reflect the potential economic value creation on building out of the landbank.0x and 12. rather than adjusted TNAV. which is likely to result in sluggish earnings growth.4-9.5x. In theory. Debt-to-GDP ratios and fiscal deficits also indicate the availability of future public finances. despite a weaker developed-world macro-economic outlook. Using accounting TNAV.0x and 6. in our view. which can usually be tracked on a monthly basis. rendering crosssector relative valuation difficult.5-5. which may lag if the housing inventory is high. To calculate adjusted TNAV. does not reflect the fact that:  The land write-downs which have been taken to date (which determine reported NAV) have not been enough to restore profitability and returns to levels that an investor would deem acceptable on new investment. however.  Each company has applied different assumptions to determine land write-downs. Light-side producers are now trading at forward EV/EBITDA multiples at or just below their averages in 2004-06. The housebuilders trade on forward price to tangible book multiples (TNAV).7x respectively on consensus 2012e estimates– discounts to the respective long-term sector averages of 7. They determine the level of buyer enquiries and housing sales (proxies for short-term housing demand). namely forward looking EV/EBITDA and price/earnings (PE) multiples. which should provide an incentive for development.

volume growth decelerates – only offset by emerging markets – and price elasticity is greater. especially as saturated US and European categories tend to become zero-sum games that are costly to expand.besnard@hsbc. sugar. Paris Branch +33 1 56 52 43 26 cedric. It is dominated by several large. and not all categories benefit as much from emerging markets. However.
Raw materials
Raw materials are a key part of manufacturing cost. Reckitt. Cyclicality is limited by the relatively small share of discretionary purchases in its sales in most categories. That means input-cost price volatility is a key issue. despite limited private label presence. Reckitt tends to focus on niche categories such as dishwashing and air and toilet care. Each category goes through a life cycle from growth. or HPC. such as Unilever. cocoa (Nestlé) coffee (Nestlé). such as bakeries. Managing the distribution channel.EMEA Equity Research Multi-sector September 2010
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Sector description
Coverage: Our universe of stocks consists of two segments: food manufacturing and home and personal care. through negotiations with retailers on price and also in such areas as on-shelf availability. so operating leverage mostly depends on volume growth to cover cost inflation. is also very competitive. to maturation. Cosmetics. European big-cap companies tend to focus on a few categories. Skin care and baby food are still taking off. such as Nestlé. Pricing power is more limited than it seems. It can quickly inflate the cost base and require risky price increases to offset it. and some combine both. They are shaped by the leading brands and by innovation. Unilever). giving the impression the food industry is highly concentrated. Almost 40% of sales is derived from emerging economies. Other parts of the industry. others on HPC. Sector categories like dairy products and skin care are not fixed entities. but mostly Henkel. Raw material and packaging costs represent about 15% to 25% of sales for cosmetics players – higher product prices imply raw materials and packaging represent a lower share of the product value – but around 30% to 35% of sales for food and home care. The home-care industry is much more concentrated. for example. vegetable oils/palm oil (Unilever). such as L’Oréal. or water. from milk to petrochemicals or vegetable oils. Procter.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. Although the companies are huge. The soap and laundry mass markets are already decently penetrated in some emerging economies. are left to smaller players or private labels. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Emerging markets
We estimate the industry has increased its exposure to emerging markets by at least 50% in 20 years. These companies usually hedge by three to six months for most of
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. Some of them focus on food.
Cedric Besnard* Analyst HSBC Bank Plc. from hard discounters to department stores. international multi-brand groups. competition is also growing. since companies have been targeting the low end of the income ladder for years. fruit and vegetables. Sector characteristics: Food and HPC is historically a defensive sector. Brands and categories: Food and HPC companies rely on brand awareness. is key. such as nutrition. when concentration is high. The main commodities are milk (Danone being the most exposed for its yoghurt business). Unilever and Henkel dominate in European laundry. oil-related/PET/plastics (everybody. and represent the biggest growth driver in coming years. tea (Unilever). confectionery and ice cream. where category growth is driven by rising income per capita. These markets account for more than two-thirds of the sector’s sales growth (sometimes 100%). which implies a migration towards branded products. driven by an increase in the penetration rate. demographics and urbanisation.

low price. with its organic growth potential the sum of three drivers: category mix. However. specialty household).
Pricing power (or the lack of) and the rise of the “trading down concept”
In a context of growing demand and low price elasticity. input cost inflation would be a structural issue to bear in mind. frozen/chilled) or where the perceived needs can easily be ignored in favour of the benefits of more “vital” needs (make-up. usually driven by the “more benefits” argument. geographical mix and execution – the capacity to gain market share and roll out innovation. In a sector focused on premiumising brands and creating new needs. A category can always be rolled out in new countries. However. in some categories. We believe the return on mix. A commodity like milk is less visible. the clear earnings growth driver over the long term. for example – and a good execution track record seem most important. The end game for all companies is to find the right balance inside the cubic matrix to generate sustainable organic sales growth. excluding FX and M&A. thus making their life more difficult in inflationary times. when price increases are implemented in the context of the consumer’s falling available income. implying that price variations tend to have an impact on gross margin with a time lag. can range from high-single-digit to low-single-digit. which companies fuel with R&D (to create the claim) and advertising and promotions (to justify it). Pricing (ex mix) over 19912009 was below 2% a year in the food industry. implying low pricing net of inflation. price elasticity can cap the companies’ ability to raise prices for more than a year (in the case of external shocks like input-cost inflation). but being in growing countries but with mature or competitive segments. (2) Mix – basically introducing a new product but with a higher price. in an industry not over-reliant on cost-cutting. A combination of growing categories – those that aren’t too mature or competitive and provide pricing power. when successful. but organic sales growth. a return to non-branded. When input costs start to bite. Furthermore. Each company can be seen as a cubic matrix. more basic substitution products (usually private labels) is a setback that is sometimes hard to survive.
The components of organic growth – watch for volume growth
Organic growth in food and HPC is driven by three metrics: (1) Price increases – these are a less important driver than some may think. This risk is reinforced by a dreaded consumption pattern: down-trading. may offer less visibility. down-trading is not as new as in the 1990s. or with execution issues.
Sector drivers
The “cubic matrix”
Most of the companies are exposed to the same consumption trends. as raw materials and packaging account for a higher share in the profit and loss of these low-priced/low-marketed products. since it’s not quoted and needs to be purchased locally. and input cost inflation is far worse news for private labels.EMEA Equity Research Multi-sector September 2010
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these commodities. is quite high – a significant part of the fixed
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. the risk of a volume backlash is high. but the short-term implications would be mitigated by easy price increases passed on to a more willing customer. Some of these commodities are either regulated (EU sugar) or quoted (cocoa). the debate is on whether the company can offset them with price increases (or emergency cost savings). We believe that down-trading is a risk in categories where brands have difficulty claiming specific health benefits (chocolate.

So are biscuits: 10am. But you do not want to be the first to cut marketing. then noon. where growth investment is key to winning market share and delivering operating leverage in the long term. mix is a tool with little visibility (trading down is a common pattern in the industry) and requires strong innovations to be a sustainable driver. but from phasing to shortterm cut the border sometimes becomes blurred. Marketing expenses are not only linked to growth. This is generally not considered as a positive. Companies entering new emerging markets.EMEA Equity Research Multi-sector September 2010
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cost remains the same as the product that’s replaced. Consumer staples evolve in a multi-brand-driven environment. but with a higher price. at the risk of being the only one.
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. Excluding innovations. where everybody has an interest in pushing the A&P level down. The share of voice will remain constant and the brand franchise untarnished. A greater focus on market share would be the last step in a category life cycle. we do not believe A&P ratios should go down structurally in coming years. putting aside the profitable but cyclical mix element. product activity and launches. It’s true that what counts is the share of voice – the proportion of a company’s advertising as a percentage of the industry’s total advertising spending. It’s more an inflationary fixed cost – but in real life it’s also partly a variable cost. Increasing the frequency of usage is usually more important when increasing the number of consumers becomes harder. This is clearly when the cost of growth becomes very high and requires costcutting – or M&A. can increase volumes. but nobody has an interest in moving first (especially when savings can afford you some leeway in your margin phasing). to justify price levels. Most of the growth comes from a natural flow of consumers to the product. execution or price cuts. since the rising number of users is driven by rising income per capita. As a result. not less. There are numerous examples of A&P phasing when margins are under pressure. We believe there are three main drivers to volume growth.
A&P: a critical tool to drive volume growth
Advertising and promotions. is a key to driving volume growth. They also can be a short-term adjustment tool to smooth margins. That said. or A&P. We see here a classic dilemma. once the cost of creating the category has been passed on. An increase in the number of consumers. though. It occurs when a category is fully penetrated. There are various ways to generate volume growth. primarily driven by categories increasing their penetration in a country. Shampoo would be a good example: adding conditioner to regular shampoo. They need to be generated by advertising and promotions. making consumers migrate towards branded goods. (3) volume growth is the driver offering the most visibility and thus the most looked at. some cheaper than others. We do not consider A&P a variable cost in a marketing-driven environment. then mid-afternoon. It represents about 12% to 15% of sales in the food industry and as much as 33% for the cosmetics industry. A&P can go down if the industry overall is cutting marketing spending. market-share gains are the only driver of volume growth. provides a rather cheap volume driver. private labels have appeared in mature regions as credible alternatives and roll-out in new regions has been completed or has become a necessity. for example. especially as tough times demand more A&P. Beyond the normal productivity gains slightly deflating the marketing expenses ratio.

unlike peers. only the EBIT margins are really comparable since IFRS restatements in 2004. In terms of disclosure. But the industry premium to the market at the end of last year (100% in November 2008) was unsustainable. it does not report "temporary" rebates inside pricing (which peers deduct from pricing) but below the line (added to A&P).EMEA Equity Research Multi-sector September 2010
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M&A: buying growth
When categories start to become too saturated or competitive. Accordingly. while over 2004-07 the HPC sector traded at c70% premium to the market. far above its previous peak of c65% in 2002 and compared with a 1998-2009 average of 39%. Reckitt bid for SSL to get access to new categories as its own home care segments are under pressure in Europe. The sector’s PE relative to the market peaked at the end of November 2008 at a 100% premium. We agree they are the most important. This results in frequent misunderstandings with analysts and stock market corrections. rather high visibility on sales growth and resulting operating leverage. DCF is the traditional tool. relying on growth synergies. given their stability. across the whole sector. the valuation range is quite wide. The food industry has on average traded at a c20% premium to the market since 1998.
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. but Danone paid a rich 22x EBITDA. most companies split out organic growth between price/mix and volume (which is the key metric investors look at). but they also take longer to achieve and are harder for the market to quantify. it is worth bearing in mind that Nestlé’s reported pricing is slightly inflated by the fact that. rather than on cost efficiencies. However. it was pricing in total resilience to a consumer slowdown. a function of strong visibility on top-line growth and FCF generation. We believe the best example would be Danone-Numico: this deal made a lot of strategic sense. deals thus often rely on growth synergies. To value the companies. explaining the 2007 share price correction. In a sector where profitable growth is the key valuation driver. As a result. From an accounting perspective. Kraft bought Cadbury to diversify away from the saturated US cookies and cream cheese categories.
Valuation: equity characteristics and accounting dilemmas
A structural PE premium to the market
The food and HPC sector (the weighted average of the stocks under our coverage) has almost always traded at a premium to the broader market since the start of our relative PE historical analysis in January 1998. at least every half year. it is tempting to buy market share or new categories through M&A (balance sheets are usually healthy due to a good cash conversion) rather than over-invest to expand categories with limited potential. and usually disclose their A&P investments.

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations

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European food retailing sector

EMEA Equity Research Multi-sector September 2010

Consumer & Retail - Europe

Food and HPC
See sector section for further details

Beverages

Food and Retail

General Retail

Luxury and Sporting Goods
See sector section for further details

See sector section for further details

See sector section for further details

Not purely online

Online

Ocado

UK
Morrison Tesco Sainsbury Casino

Europe
Carrefour Jeronimo Martins Metro Ahold Delhaize

Source: HSBC

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Performance of European food retail stocks 1990-2010

EMEA Equity Research Multi-sector September 2010

600

Merger CarrefourPromodès (1999)

Delhaize buys Hannaford (2000)

500 Promodès launches unfriendly takeover on Casino (1997) 400

Morrison buys Safeway (2004)

300

Auchan buys Docks de France (1996)

200

Sector boosted by property valuation (2007) Wal-Mart buys Asda (1999)

100

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Stock performance
Source: Factset, HSBC

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It has always been seen by investors as a defensive sector. and is not registered/ qualified pursuant to FINRA regulations
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. In the 1990s. discounters. Jeronimo Martins. few listed players are pure food retailers and even discounters are exposed to economic slowdowns.  Discount stores enjoyed faster organic growth than other formats in the past decade.  Department stores have multiple categories functioning as different business units under one roof.000 square metres per store) that focus on volumes.500 square metres per store) are medium-sized stores focusing on groceries.  Discounters have smaller stores.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc. but we believe this is no longer the case. a third of its level in the 1960s. Ahold and Delhaize still sell mainly food.  Hypermarkets are large stores (above 5. with a limited non-food range and about 13. food retailers with negative working capital benefited from high inflation and high interest rates. That trend has since reversed in France and Germany as hypermarkets started to compete more on price and as the economic crisis curbed spending by lower-income households.  Convenience stores offer a variety of food and are generally located near their target customers. supermarkets. at least by sales. who are prepared to pay higher prices than in hypermarkets or discount stores as a result. They are sometimes national chains and often carry the largest number of SKUs.EMEA Equity Research Multi-sector September 2010
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Sector description
Food retailing is the largest consumer sector. taking market share from hypermarkets and supermarkets in Germany and France and even in the UK. convenience stores. Metro and Carrefour are the most exposed to non-food. according to the Institute of Grocery Distribution (IGD). which often reflect market positioning: premium. sector performance was driven by international expansion and consolidation in mature markets. In the 1980s. catering customers and small retailers.  Supermarkets (around 2.  In mature markets. Food spending has shrunk as a percentage of total spending.000 SKUs in grocery. The top five market shares now exceed 50% in the main European countries.samuel@hsbc. restaurant.  Few listed food retailers are pure food retailers and therefore largely immune to a slowdown in discretionary spending. mass or value-oriented. cash and carry and department stores. Paris Branch +33 1 56 52 44 23 jerome.000 stock-keeping units (SKUs). with EUR146bn of revenues in 2009 in the UK. spending on food as a percentage of total household spending has continued to shrink and now accounts for an average 14% of consumer spending in mature European markets. fewer SKUs and aggressively promote non-food items. There are several reasons why the sector is not as defensive as it was. Morrison. offering up to 50. The industry operates in various store formats: hypermarkets.  Cash and carry stores offer low prices but only sell groceries and general merchandises in bulk to hotel.
Jérôme Samuel* Analyst HSBC Bank Plc. they sell groceries and general merchandise.

the top line has helped drive returns for investors. Most food retailers try to have their international activities self-financed in local currencies and are not hedged. A typical discount store will have a leaner cost structure than a hypermarket.  Extent of opening programmes: Retailers plan store openings to improve coverage. Modern retailing is still at an early stage of development in emerging markets.5%. Brand awareness and private labels are key success factors in food retailing. offerings and loyalty programmes. or retail space per capita. which has two types of players: conventional retailers that have added online retailing and pure online retailers such as Ocado. In all mature markets.EMEA Equity Research Multi-sector September 2010
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 Among other formats. since margins tend not to change much. Although most of the sourcing is
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. thereby bearing significant forex risk. private labels now account for more than 25% of their sales. loyalty programmes. private labels are growing much faster than national brands. along with location. identical) sales growth: the constant currency sales growth in stores that have been open more than a year (the duration may differ slightly from company to company). complementing the coverage of existing stores and adding new space that will later contribute to like-for-like growth. The UK is the leader. new stores and acquired/disposed of stores. since although private labels are sold at lower prices than national brands (c25% on average) their costs are discounted to an even greater degree. A supermarket enjoys a higher gross margin but provides a higher level of service in store. supermarkets and discount stores about 5. but French. the lower the growth potential. excluding forex. They attract customers and help build their loyalty. German and the other European retailers are catching up. Large food retailers are present in multiple countries. through such techniques as better branding. not necessarily in terms of cash but in percentage terms. retailers keep opening new stores and increasing store sizes. We estimate hypermarkets have an operating margin of 4. Historically. Organic growth represents increases in sales ex-currency effects and ex-M&A. with private labels representing more than 40% of retailers’ sales. Besides company-specific factors (eg brand awareness.  Exposure to growth markets: Although currency fluctuations and shorter economic cycles may increase earnings volatility. the higher the retail density. A weak currency may have a positive impact on financial interests by lowering net debt. with lower gross margin but also much lower SG&A.
Key themes
Top line: Organic sales
An important metric is like-for-like (same-store. Private labels ensure higher margins for the retailers. emerging markets offer a good opportunity for top-line growth.5% and convenience stores higher. Like-for-like gives an indication of how the retailer has performed in attracting more customers and increasing sales per customer. pricing. there are structural differences explaining why some retailers enjoy faster sales growth than others:  Maturity of the domestic market: As a general rule. promotional activity). it is worth highlighting the emergence of online grocery retailing. With top-line growth opportunities drying up in existing stores. It gives a fair representation of actual sales growth.

For example. Asda.
Economy/inflation
Moderate inflation is good for the sector. For example. which may make sense if each lacks critical size. the currency exposure still brings volatility to the top line and the bottom line.
Sector drivers
Consumer confidence
In mature economies. lowering prices. getting the offer right. driving volume and finally improving operational profitability. emerging markets are a source of growth.  Exposure to different formats: Different formats have different dynamics and may grow at widely differing levels even in the same region. consumers do tend to trade up in confident times and vice versa. Although the sector withstands shocks well. Emerging markets are structurally different. Carrefour and Tesco agreed to swap some Tesco stores in Taiwan for Carrefour stores in the Czech Republic and Slovakia. especially in the case of cross-borders deals where buying synergies have been made on a national basis. discounters lost market share in 2009 as a consequence of greater price competitiveness from hypermarkets in France. describes the virtuous circle of its trading model as buying better. for example the ability to harness synergies in purchasing and distribution for different banners within the same company. Economies of scale provide an opportunity for significant cost savings.
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. most of the major food retailers have been executing cost-saving plans. low prices help to drive higher volumes through gains in market share. In other words. Sometimes retailers also swap assets. for example. Building efficiency in logistics and optimising store size also helps improve margins. consumer confidence is one of the main drivers of the top line.
M&A
Big mergers like Carrefour-Promodès in 1999 and Morrison-Safeway in 2004 had problems with integration and value creation. improving quality. and many players enter them through acquisitions. macroeconomic factors such as rising per-capita income and expenditure levels help sales growth.
Cost savings
Of late. Since 2009. which in turn lead to better buying conditions and hence the ability to offer even better prices to customers. Most synergies announced at the time of the deals have not been delivered. In general. Their low per-capita incomes and lower retail penetration provide room for significant long-term structural growth. However. the focus for large retailers has turned more towards cost savings (mainly Carrefour and Metro) and subsequent margin improvement. As the top players enjoy major market shares in mature markets. The worst scenario for food retailers is deflation. it helps both the top line and the bottom line for those who have pricing power. few developed countries offer opportunities for consolidation.EMEA Equity Research Multi-sector September 2010
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done locally. if not the margins. in 2005.

Valuation: equity characteristics and accounting dilemmas
Capex is a leading indicator
On average. Tesco’s Clubcard has been one of the most successful.
Distribution costs
Distribution costs are not entirely comparable because retailers do not all account for their costs in the same way. EBIT is generally comparable as it includes both rental costs (for leased property) and depreciation (for freehold property). capex for food retailers is expected to equate to 3.6% of net sales in 2010e.
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.5x in 2011e and on a 2011e PE of 11. The presence of comparable peers means relative valuation can also be used. private labels
Food retailers have been developing ever more attractive and innovative loyalty schemes. compared with 4. Loyalty schemes have been found to work well for retailers in terms of improved repeat purchases and consumer data collection.3x at which it traded on average between July 1999 and August 2010. We estimate the food retail sector in Europe now trades at EV/sales of 44% and EV/EBITDA of 6. food retailers focus on increasing the share of private labels in total sales. Obviously.9x. Formats.EMEA Equity Research Multi-sector September 2010
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Loyalty programmes. However. the property strategy (freehold or leasehold). One of the sector strengths is that total capex comprises a multitude of small investments. Private labels command higher margins for food retailers with lower prices for consumers. compared with the 16.
Valuation
Most of the major international food retailers provide good revenue and earnings visibility. assortment. Hence. reflecting the economic crisis. the food retailers that have performed best have been mono-format retailers with a strong concept and brand awareness and the ones that have managed to secure loyal customers. making EBITDA comparisons difficult. exposure to non-food and the level of service in stores have a direct impact on distribution costs and margins. offering more flexibility in a downturn. the average PE relative to the DJ Stoxx 600 for European food retailers was c103. The data collected from such schemes lead to useful insights in tailoring the offerings and increasing loyalty further. Over the long term.
Property
The level of property ownership is different for different companies. During the same period. the proportion of owned stores vs franchises and the regions of expansion. a discounted cash flow model may be used to value them. Capex comparisons between retailers can be distorted by the nature of the business (mix of food vs non-food).8% in 2008.

G . TW .mistry@hsbcib. Head of European Insurance HSBC Bank plc +44 20 7991 6756 kailesh.M alays ia. The chart below illustrates the widely referenced S-curve in the industry. Life insurance accounted for 57% of premiums.Italy. Life insurance comprises two main classes of products: savings products.J apan. referred to as Solvency I in Europe.H ungary. and non-life for 43%. The global insurance industry generated USD4.France. and is not registered/ qualified pursuant to FINRA regulations
16% 14% 12% 10% 8% 6% 4% 2% 0% 100 1. SW . which cover death and disability and whose margins are linked to underwriting and technical factors such as mortality and morbidity. and may be used as an indication of potentially high-growth markets as GDP per capita increases. with around 28% of the global premiums.H ong Ko ng. Insurance companies have also expanded into accumulation products where there may or may not be an insurance element. Jap .066bn of premiums. P H-P hilippines.Germany. I . SA . T H -T hailand. N . usually unknown. HSBC estimates
The sector has a mix of mutual and listed companies. Health insurance covers medical expenses and often belongs to the primary life segment. Reinsurance refers to the way primary insurers insure themselves against the risk. IN . Some insurers also have banking and asset management operations alongside the typical life and non-life underwriting segments. Primary insurance. The unknowns make estimating profits difficult and give rise to accounting that has been a topic of debate for investors and insurance companies for some time now. or about 7% of global GDP.Indonesia. The
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. P L . The US is the largest insurance market. or non-life.EMEA Equity Research Multi-sector September 2010
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Sector description
Insurance companies provide protection to individuals and businesses against uncertain events by transferring risk to an underwriter.C hile. F ra .Switzerland .C zec h R epublic .Ro mania. whose total market capitalisation equates to about 6% of that of the DJ Stoxx 600. followed by Japan and the UK. The current solvency calculation. SP .Netherlands . which highlights the level of maturity of the insurance market and per capita GDP. C L .
Proportion of GDP spent on insurance versus per capita GDP in 2009 (USD)
Kailesh Mistry* Analyst. for which margins are tied to investment returns or fees linked to asset values as well as insurance protections offered.com Dhruv Gahlaut* Analyst HSBC Bank plc +44 20 7991 6728 dhruv.C anada. which promises to pay the insured an amount. The sector is divided into primary insurance and reinsurance. depending on the nature of risk underwritten. is further split between life and property and casualty. ID .Aus tralia.India.South A fric a. H K . C . is a nonrisk-based measure which is inconsistent across different countries.So uth Ko rea. which underwrites risk directly from households and businesses.Singapo re.com Thomas Fossard* Analyst HSBC Bank plc.gahlaut@hsbcib. RN . CH .T aiwan.
Key themes
Regulatory and accounting changes: Introduction of new regulatory solvency and accounting standards are a key theme in the sector.Po land. in 2009.000
C ountry legend: A us . C Z .com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. SK . Paris branch +33 1 5652 4340 thomas. if those events occur.000 IN CH PH ID TH MY BZ CL RN 10.C hina.000 PL HN SA
TW UK SK N SW
HK F ra Jap C US I SP G AU S
CZ
100. BZ . making comparisons difficult.B razil
Source: Sigma. HN . and personal risk products.fossard@hsbc. M Y.

That said. the reinsurance segment could be a key beneficiary of the Solvency II regime. For example in the UK personal motor insurance market we see a hardening or increase of insurance rates as a result of significant deterioration in underwriting profitability. Primary non-life segment: Premium growth. reducing policy administration costs and moving to lower-cost distribution channels. which varies by country. evolution of pricing. Focus on efficiency: Insurance companies have increasingly focused on efficiency and cost reduction over the past few years. although the approach to the calculation of capital requirements appears to be more consistent. In a report on cost-cutting potential. The industry has tried to reduce costs through integrating back offices. Increasingly life insurers have been focusing on improving underwriting profitability through action on prices. New standards are being considered and will be introduced over time. centralising group functions. There is also greater demand for insurance company cash flow disclosure. For example. In theory. There is a similar debate on accounting standards. off-shoring jobs to low-cost-centre territories. forcing insurers to improve underwriting profitability rather than subsidising present-year losses through positive prior-year development and strong investment results. and the US is reviewing its capital adequacy requirements. Despite a high claims burden in H1 2010. We expect a reduction in the retention rates by primary
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. which diverge between regions. Primary life segment: Life insurers have emerged from the financial crisis with an improved capital position. The European Union plans to introduce risk-based Solvency II by 1 January 2013. which varies by product and region. we analysed 49 insurers across Europe and estimated cost-restructuring potential of EUR24bn in our base case. In addition. the trend to move away from high upfront commissions paid to distributors to level-loaded structures is helping to improve the cash flow credentials of the sector. which is expected to generate additional demand for reinsurance from smaller and less-diversified insurers as well as mutuals. cutting headcount. phone and affinity tie-ups to sell non-life insurance. this should increase consistency. reinsurance capacity still exceeds demand. guarantee rates and charging for specific features. In our view. However. The life insurance industry is also seeing a transition to embedded value accounting to market consistent embedded value (MCEV) from European embedded value or traditional embedded value. which forces an increase in insurance rates. Prior-year reserve releases have declined across Europe while investment returns remain under pressure. There has also been a focus on lowering administration costs and reducing dependence on investment markets by moving to fee-based products. this theme has been driven by pressure on underwriting and investment margins. We are also seeing a shift away from the usual broker/agent distribution channel towards greater use of internet. claims inflation. IFRS Phase II is due to be implemented in 2013. the catalyst for the reinsurance industry remains large claims events. as in the past. which is putting prices under pressure. Reinsurance segment: The industry is similar to the primary non-life segment in terms of having an underwriting cycle and a conservative investment portfolio relative to the rest of industry. China is also moving towards a risk-based system. especially in the personal motor and property segment with the aim of reducing distribution costs.EMEA Equity Research Multi-sector September 2010
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inconsistency primarily relates to allowable capital resources. investment returns and changes in distribution are the key themes for this segment. the increasing maturity of the industry and the consequences of shareholder ownership rather than mutuality. The balance of these factors will differ over time and affect the underwriting cycle. while avoiding forced capital raising. prior-year reserve development. some of which has already been executed or announced.

Asia ex Japan.3% 1 1. and Taiwan and Central and Eastern Europe remain attractive regions for insurance companies to expand into. A minimum rating is required to underwrite business in reinsurance as well as certain lines of businesses in the non-life segment and life segment.4% 8. and is relevant to both primary and reinsurance segments.1
P re miu ms gr o wt h (10 ye ar C A GR )
Source: Sigma. Importance of emerging markets: Emerging markets have lower insurance penetration than developed economies and offer significant opportunities for expansion. fee structure.2% 1 % 0. like banks. As income rises. demand expands from compulsory products (motor insurance) to more sophisticated products such as saving products.8% 11 .9% 5.EMEA Equity Research Multi-sector September 2010
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insurers. Management teams have taken action to improve the capital position by reducing risk. needs to maintain a minimum level of solvency to be able to underwrite new products and honour its future liabilities. Insurance companies based in developed markets have shown their desire and willingness to expand in these regions and we expect the trend to continue.7% 5. As already highlighted.1 % 3. to increase the demand for reinsurance as the primary segment continues to de-risk its business models.
Premium growth was significantly higher in emerging markets than the developed market during the period 1999-2009
Wo rld Industrialised co untries Em erging m arkets Japan Nor th A merica Oceania West ern Euro pe South & East A sia LATA M M iddle East & C entral A sia Ot her Euro pe 0% 2% 4% 6% 8% 10% 1 2% 14% 1 6% 1 8% 0. Underlying profitability: Underwriting profitability and investment returns are key elements of operating profits. which have reached their highest points since 2002. Investors screen companies using regulatory and rating-agency models to measure the group’s solvency position and gauge its financial and operational flexibility. The growth story is well supported by the recovery in their GDP growth. The adoption of a risk-based approach to the calculation of capital adequacy and quality of capital are the next steps in the debate on capital adequacy. life insurers continue to move away from higher capital-intensive products and have emerged in a much better state from the crisis as a result of management actions implemented since the 2003 crisis. HSBC estimates
Sector drivers
Capital adequacy: The insurance sector. asset protection such as household insurance and retirement products.9% 18.8% 20% 5. disposing of assets. Underwriting profitability depends on the pricing of products. Regions such as LatAm. saving on costs and focusing on underlying profitability. Underlying profitability at life
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. high rates of household savings and lack of social security structures in some of these countries. Increase in GDP and per capita income: Growth in the economy and per capita income boosts demand for insurance.1 % 7. claims experience and expenses.

Premiums are paid in the short term. although surplus reserves. The methodology for calculating EV has changed over time. although there are still concerns about its comparability and consistency among insurers and regions. Given the complexity in comparison and valuation. Our view on the level of sustainable returns is based on the company’s track record and our forecast of future performance. Also. Currently life insurers have a higher exposure to riskier assets like equity and corporate bonds. EV is the present value of the future cash flows that are expected to emerge from the in-force book of the life insurance company together with the value of shareholders’ net tangible assets.EMEA Equity Research Multi-sector September 2010
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companies is dependent on the type of product and can be broadly broken into risk result and investment spread for the traditional product – which are generally split between policyholder and shareholder in a defined proportion – and fee income for the unit-linked product. with life insurers having a longer duration as a result of the longer maturity of liabilities. including book value (BV). In simplistic terms.
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. earning multiples. which uses capital and/or earnings multiples to reflect our views about the sustainability of returns by business line. some insurers have already adopted market consistent embedded value (MCEV) principles. We have already mentioned the increasing focus on efficiency and changes in distribution cost structures for both the primary life and non-life segments. but the risks are shared with policyholders in the life segment – assets are largely managed on behalf of policyholders. while others are in the process of doing so. while reinsurers and primary non-life insurers are mainly invested in shorter-duration bonds and cash. may be released to improve or smoothen profits. and instead increased their exposure to corporate bonds and alternative investments. In the past 10 years. the BV calculation is fairly straight-forward as investors use IFRS estimates. premiums have grown twice as fast in emerging as in developed markets. but liabilities are paid over a long period. Surrender and lapses of policies also affect profitability at life insurers and have to be considered for calculations along with expenses. cash flow multiples and dividend yield. the latest in the series.
Valuation: equity characteristics and accounting dilemmas
Investors consider several metrics when valuing insurance firms. the current IFRS metrics do not fully reflect the true profitability of new business and are inconsistent in their treatment of assets and liabilities. Inadequate reserves will need to be replenished. Investment exposure: Investment exposures have changed over time as insurance companies have lowered their gearing to equity markets from the levels seen at the start of the decade. Shareholders are fully exposed to assetquality risks in the non-life segment. In Europe. if any. Primary non-life and reinsurance companies measure technical profitability based on the combined ratio. but for life companies there has been ongoing debate about the use of IFRS or embedded value (EV) estimates to calculate BV. For non-life insurance companies. possibly funded by shareholders. and we expect EM growth to remain higher. We use a SOTP methodology to calculate the fair value for companies. Our 12-month target prices are based on our SOTP. we are seeing an increasing focus on the operating cash flow of life businesses. Adequate reserving: Prudent reserving is critical for insurance companies. Premium growth: This vital aspect depends on factors ranging from economic activity and development of the insurance market to government policies and social security systems. Bond duration also varies. the total of claims paid and losses incurred versus the premiums collected. The use of different methodologies for calculation of EV and lack of sufficient disclosure makes comparisons difficult among insurers and leads to investors examining both IFRS and EV metrics. given reliability and acceptance of EV metrics.

Many listed companies are family-controlled.dargnies@hsbc. market. which sells jewellery.  Hard-luxury companies: “Hard luxury” describes products such as watches. M&A has been a driver in the past. Monobrand companies include Tiffany. The key concern is the sustainability of their growth. with its fragrances and wines and spirits. Monobrand listed companies include Burberry. although pens no longer contribute much to sales. watches and jewellery and selective distribution. Jewellery is often retail-driven – companies sell their own jewellery in their own stores. with the star brand Omega.
Antoine Belge* Head of Consumer Brands and Retail Equity Research. It seems paradoxical to try to sell more of what theoretically should be exclusive. which now has more than 50 brands in five different product categories: fashion and leather.  Diversified groups/holdings: Some of the listed companies in the space have grown by acquisitions that gave them large. and Bulgari. diversified brand portfolios. which sells mostly jewellery. The largest hard-luxury companies are Richemont. Tod’s and Coach. brands. The sector is characterised by high operating margins. PPR is more of a conglomerate than a diversified luxury group. such as the watch-component division of the Swatch Group.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. for example – synergies are scarce. Paris Branch +33 1 56 52 43 47 antoine.com Erwan Rambourg* Analyst HSBC Bank Plc +44 20 7991 6793 erwan. distribute and sell high-end apparel. Some luxury goods companies are also involved in other premium-priced goods. or in businesses that are part of a vertical integration drive.rambourg@hsbcib. but with a few exceptions – Luxottica. with its star brand Cartier. that has been the case in some countries. substantial emergingmarket exposure and strong cash generation. since it holds retail assets. Hermès. watches and fragrances. fragrance and cosmetics. Most of the key themes in the sector will revolve around image management. prices and functionality. wines and spirits. To a certain extent.com Sophie Dargnies* Analyst HSBC Bank Plc. making it hard to return cash to investors in an efficient manner. but the leaders of the industry have walked a fine line between selling in volume but holding on to their identity (and the consumer). Watches and jewellery are often considered together. Paris Branch +33 1 56 52 43 48 sophie. and the key question for the bigger brands like Louis Vuitton and Cartier is how close the brand is to being mature. because consumers want to compare designs. Watches are wholesale-driven. a stake in sports brand Puma and a luxury portfolio. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Luxury goods stocks historically have been strong growth stocks trading at a premium valuation to the market. Europe HSBC Bank Plc. watches. Soft-luxury goods are mostly sold in directly operated stores. leather goods and accessories.belge@hsbc.  Soft-luxury companies: “Soft luxury” describes high-end apparel and leather goods. but their distribution structures vary considerably. The proxy for the sector and the largest group is the French company LVMH. Christian Dior is a listed holding company of LVMH. But consumption of luxury is
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. produce. such as LVMH. although they focus on so-called hard luxury. such as Burberry and Tiffany. and the Swatch Group. pricing power and the concept of maturity.EMEA Equity Research Multi-sector September 2010
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Sector description
The luxury goods sector includes companies that develop. jewellery and pens. Richemont and the Swatch Group also have diversified portfolios. although some have a 100% free float. jewellery. We believe that the key concerns and themes are:  High-end consumer behaviour – Most investors consider luxury goods demand to be directly linked to GDP growth.

currency and M&A have also had an impact on stock prices.  Market share/polarisation – Trading less implies that some brands have a reference status and will both grow when times are good and expand their market share when times are tougher. During the downturn. Since the October 2008 slowdown. but we believe companies still have considerable capacity to recruit customers and trade them up. brands tend to launch higher-priced. Historically.  Pricing power – Luxury brands do not really compete on price but rather on design and desirability. generally in France and Italy. Another recurring subtheme here is counterfeit products in luxury.  Image control – It is hard to trade consumers up if the distribution network is not up to speed in product assortment. We think in luxury goods. higher-margin products. Cartier in watches and jewellery.  Currency – Most European luxury goods manufacturers produce in euros. And if the product category is a profitable diversification in which the company has not developed know-how or a production base. We expect access to higher-growth countries and developing leadership positions there. the industry has suffered from much lower volumes. Louis Vuitton is usually the reference in leather and accessories. customers buy cheaper vodka in the US during a recession. They have important exposure to the US dollar and dollar-linked currencies such as the renminbi and the Hong Kong dollar and. for example. A consumer interested in the latest Patek Philippe watch would probably postpone buying it during an economic crunch rather than trade down to a Casio or Swatch. In recovery phases. Most brands try to control their image as much as they can. such as fragrances and eyewear at Burberry or Gucci. more or less – Linked to this pricing power and the social status that is associated with luxury.  Trading up or down. a licence makes sense. and raise prices again. to the yen. Japan and possibly a few other countries may be treated as cash cows now. consumer confidence seemed sluggish in the first half of 2010. and sell throughout the world. Luxury boomed in Japan during one of the country’s deepest recessions. both within developing countries and through customers from those countries buying goods in Europe. there is a big debate around trading up or down and trading more or less.EMEA Equity Research Multi-sector September 2010
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driven by social. After a decade of negative FX impacts from a stronger euro. increases sales by a high single-digit to low double-digit rate every year.
Sector drivers
Luxury goods have been driven by emerging-market exposure. Similarly. will continue to be a key factor for the sector. we believe the
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. That often means taking back licences or transferring sales from wholesalers to directly operated stores. such as Bulgari and Hermes. in some cases. In spirits. merchandising and in-store service. where margins are already currently higher than in the developed world outside Japan. cultural and psychological factors as well as financial issues.  Market maturity/saturation – If Louis Vuitton. high-end consumers tend to trade less when times get tough. prices generally held up. how long can this last? When will its market be saturated? This is a theoretical debate that has gone on for years. which is harder for wholesale-driven businesses such as watches or fragrances. for example. but luxury demand soared as wealthy consumers un-tightened their belts after almost two years of austerity. trading down is common.

Valuation: equity characteristics and accounting dilemmas
Luxury goods companies tend to trade on forward-looking price/earnings ratios because they are usually not very capital/debt-intensive. Historically. which can sometimes be disturbing for investors. we believe they are outweighed by the many reasons to remain excited by the country’s potential. and their equity held. Although there are theoretical risks when operating in China. but cash generation could become an issue if buy-back programs or dividend hikes do not occur.
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.  M&A and cash management – Few acquisitions have occurred since an LVMH buying spree in 19992000. people and profits is done with the long term in mind. The sector has shown how cyclical it is in the downturn and now depends on Asian growth.to high-teens range. One thing to bear in mind about investments and cost containment in the sector: most of the companies are managed. it has traded more in the mid.  Geographic diversification – The US remains an underdeveloped market in our view. Consequently. We do not believe the interesting assets have suffered in the downturn (and many theoretical targets are privately held). the sector traded in the low to mid-20x forward PE range in 2002-2007. after a decade during which FX held back earnings. But with cash piling up. Consequently. Since the downturn.EMEA Equity Research Multi-sector September 2010
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sector should now benefit from currency effects at least until the end of 2011 – hedging policies are in place – if the current spot rates prevail. But the investment case for the sector now relies greatly on Asia outside Japan. it would not be distributed in existing Louis Vuitton stores. But strong organic growth rates are likely and the rare currency boost to earnings. it could be difficult to trade back at the historical absolute PE. In absolute terms. and countries like India. management of brands. Russia and Brazil could represent growth opportunities in the future. the sector has traded at an average 50% premium to the market with troughs during which the sector was trading in line (eg following 9/11) and peaks when the sector was trading at a 100% premium (eg during the 2000 bubble). by families. The issue with acquisitions in the sector is that they do not produce many synergies – if LVMH were to acquire a leather goods brand. not necessarily the next quarter. suggests a re-rating is possible. talk about deals has resurfaced.

zinc. wire and cable manufactures and food packaging companies. including base metals copper. infrastructure and consumer goods.keen@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. Anglo American. EMEA HSBC Bank Plc +44 20 7991 6764 andrew. the industry is no longer predominantly made up of national-based steelmakers (particularly in Europe) as intra-regional and global steelmakers are becoming more common. as all producers are subject to global commodity prices and the sector has long been characterised by cross-border investment. Metals and mining is arguably the oldest truly global sector. ArcelorMittal. which can take 10 years or longer to bring on stream. nickel.
Andrew Keen* Head of Metals and Mining Research. a significant break from past cycles. although some steelmakers are also backward integrated and own upstream assets. and once growth was easily satisfied with brownfield expansion and the occasional new mine. Miners encompass many independent industries. Xstrata and Vale – the first four of which are listed in London). There is emerging evidence that this higher level of consolidation in developed countries has changed the industry from being one that traditionally competed aggressively for market share (and frequently looked to governments for support).EMEA Equity Research Multi-sector September 2010
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Sector description
The metals and mining sector falls broadly into two areas.zimmermann@ hsbcib. and is now dominated by five large companies (BHP Billiton. aluminium.com Thorsten Zimmermann* Analyst HSBC Bank Plc +44 20 7991 6835 thorsten. although these sub-sectors are closely interrelated.
Key themes
Emerging market growth
Around one-third of metals are consumed in China. As a result. now fresh capital needs to be constantly invested in new
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. Steel and base metals are key materials for construction. Rio Tinto. In the 2008/09 downturn (which represented the worst capacity utilisation cycle for a generation) major steelmakers did not seek bankruptcy protection or assistance from governments. This has changed the investment cycle in the industry. stainless and long steel). Hence. This consolidation has been driven by the desire to secure production growth more quickly than through the commissioning of new projects. and China is now about three times the size of the US as a metal consumer. each focused on the extraction and refining of metals. Mining companies also produce “bulk commodities” such as thermal coal. Major consumers include construction and automotive firms. (although SG&A costs for global mining firms are relatively low in absolute terms). The steel industry is largely a processor of raw materials into downstream products (grouped broadly as flat-rolled. and precious metals platinum and gold. and is not registered/ qualified pursuant to FINRA regulations
Mining industry
The mining industry has undergone significant consolidation over the past decade. it has been quicker and more profitable to buy than build. coking coal and iron ore (the latter two are the raw materials for much of the steel industry). The industry has produced significant excess cash flows over the past decade. mining and steel. but still struggles to accelerate production growth through greenfield projects.
Steel industry
The steel industry has also undergone significant consolidation over the past decade. Consolidation has also produced some scale benefits. led by the largest firm in the industry. to one that is producing returns above its cost of capital through the cycle. capital goods producers. The acceleration of China as a metal consumer has led to a rise in global metals demand growth from 2-3% pa for much of the 1980s and 1990s to 5-7% pa over the past decade.

but returns to shareholders can be boosted by special dividends and share buybacks when cash flows are strong. the mining industry is now dominated by very large companies that face antitrust resistance to further consolation and relatively small mining companies.
Deteriorating resources
A common theme in the sector (although one that we do not entirely subscribe to) is the deterioration in the quality of natural resources and the impact on commodity prices. Although there is further scope for consolidation in steel (especially in emerging markets that added capacity very quickly). with management aiming to avoid having to cancel core dividends (this has not proved entirely successful. This is due to the movement from rural housing and employment to urban manufacturing jobs (which require plant and infrastructure) and urban accommodation (which drives demand for materials such as steel-reinforced concrete and copper wiring). which has led to 15-20 million people being “urbanised” each year. On our estimates.
M&A versus organic growth
Buying definitely outstripped building as a pathway to growth over the past decade. companies that were early in the acquisition process (notably Xstrata and ArcelorMittal) timed their purchases of assets well.
Dividend yield or growth?
Mining stocks tend to appear to have a low dividend yield. and were rewarded with strong cash flows. This structural change in global demand has been driven by economic growth in China. processing and extraction have led to continued upgrading of known resources and a containment of structural cost increases). commodities are more dependent on “incentive pricing”. Many commentators and some in the industry claim that the quality and quantity of ore for the next generation of mines is significantly degraded from the last generation. a significant proportion of China’s population has reached the personal income band where demand for metal-intensive goods accelerates significantly.
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. which is incompatible with the claims made on an industry-wide basis. Although this trend is difficult to define and measure. Consequently. It is becoming more challenging to extract some metals but there is no evidence of reaching absolute depletion levels of minerals (the predictions made in the 1970s “Club of Rome” have proved false – reserves and resources have continued to rise over time as technological advancements in exploration. Most mining companies will also claim to have growth pipelines that are in the lower half of the cost curve and relatively easy to deliver. often with dominant or blocking shareholders. and mining companies are pointing towards uses for their cash flow over the next five years. with the balance exported in the form of manufactured goods. with three of the four major miners in the UK cancelling dividends to preserve cash or pursue rights issues during the 2008/09 downturn). which will require higher incentive pricing and lead to further delays and disruptions. During the commodity price upcycle. Therefore the industry is in the process of rediscovering organic growth. or commodity prices that are required to justify investment in projects that have traditionally been seen as marginal.EMEA Equity Research Multi-sector September 2010
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projects. 75-90% of the metal consumed in China stays in China. The low yield of core dividends is due to the cyclical nature of the companies’ earnings.

In the case of steel. the Chinese state has sought to take direct interests in a range of small and large mining companies. Due to its dependence on commodity markets. Commodity markets are relatively straightforward in principle. which has transferred ownership of 26% of minerals to previously disadvantaged South Africans. buybacks and M&A). and a recent populist push for a Resource Super Profits Tax in Australia. At the other extreme. and this has made the timing of entering and exiting stock investments increasingly important. but often complex in detail. rapid demand growth is again pushing mining firms to return to areas of higher risk like West Africa (iron ore). the difference between input (iron ore. minerals are commonly owned by the state. Remembering this simple principle (and trying to spot key inflection points) is the key to moving beyond simple momentum investing in the sector. so the fluctuating prices of metals drive margins and cash flows. it has also attracted significant interest from hedge funds. In addition. the market expects them to stay bad forever. In major mining regions. mining equities do tend to be volatile and closely correlated to near-term metal price movements. Although commodity prices have a long history of mean reversion and asset lives of mines can stretch to many decades (both implying that equity prices should not follow short-term commodity prices). in tight markets (as a result of demand growth or supply interruptions) prices will explore an upper limit. Although the sector was plagued by nationalisation in South America and Africa during the 1970s. inventories in the industry (or on exchanges for some commodities) rise and prices tend to fall to marginal cost (typically a price at which 10-25% of producers experience cash operating losses). when commodity markets are good. which is usually defined by demand destruction through substitution or the availability of new sources of supply.EMEA Equity Research Multi-sector September 2010
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Resource nationalism and political risk
Political risk is an old theme in mining that is gaining fresh momentum. and when they are bad. the Congo (copper) and Afghanistan (iron ore and copper). Given China’s dominance of demand and relatively poor endowment of minerals (it is a major importer of iron ore and copper in particular). and mining companies operate mines under systems of mineral leases and royalties. There are few ways to invest in the sector without taking a view of the underlying commodity markets for a stock (such as spotting excess cash generation. In periods of poor demand. scrap and coking coal) and output (finished steel) prices. For miners. It is likely that this will remain an issue in the sector for the foreseeable future. this is not surprising given that their costs and output levels are broadly stable. and the metals and mining sector is high beta versus the broader market. The “risk trade” of buying or selling a high-beta sector on economic data points (particularly those associated with Chinese economic growth or trade) is growing as a trend. and this faster money has tended to amplify the sector’s beta. Given the sector’s size and volatility. Metals markets typically work between two dynamics. This leads to an inevitable supply response and returns a market to equilibrium.
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. global economic growth is a major driver of stock performance. often with some political resistance. as well as operating rates. In simple terms.
Sector drivers
Commodity prices undoubtedly drive movements for all types of metals stocks. the market expects them to stay good forever. are critical for forecasting margins. more recent trends include the empowerment process in South Africa.

1x P/book.EMEA Equity Research Multi-sector September 2010
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Valuation: equity characteristics and accounting dilemmas
Mining companies
Mining companies tend to trade strongly on cash flow generation. Consequently. Although earnings multiples are very volatile through the cycle. as one-off items can be significant (inventory write-downs. in part due to the slow asset turns in the industry.000/t of steel). only costs remain a variable). It is still up for debate if the higher consolidation that occurred in 2002 and 2006 will transform into structurally higher margins for the industry and allow higher valuation multiples going forward. including joint ventures and interests in separately listed subsidiaries. Steel mills tend to generate a fair amount of cash flow during upcycles. have a revalued book. Stated earnings are not readily comparable. comparisons on book value metrics can be difficult. hedging gains/losses) but the assessment across companies differs significantly about what should be regarded as non-recurring items. Write-downs to historical book values have not been a negative catalyst for stocks in recent years. they are also more vulnerable to fluctuations in the prices of key raw materials and variances in capacity utilisation. giving detailed data on production (such as grades and tonnages). particularly guidance for the quarter ahead. however. Book valuation metrics for the miners are less relevant. as this is frequently spent on acquisitions and very costly greenfield plants (capex cUSD1. with EBITDA broken down into broad regional or product groupings. Longer-run cash flow measures such as DCF/NPV are also commonly used (often based on mine-life expectations) although these valuation approaches are less anchored than might first be expected. earnings releases are rarely a catalyst for stock performance (as production and prices are known. Some miners are operating assets that have been in production for decades and are carried at a heavily depreciated book value.
Steel companies
For steel companies. Steel company earnings tend to be more difficult to model than for miners – as a processing business on top of volatility for product prices. Although generally very volatile as a sector. which have made large acquisitions. restructuring costs. Steel companies tend to report much less information than miners. As a result. Consensus earnings comparison for the miners tends to focus heavily on EBITDA. Over the long run. major miners have typically traded at around 90% of the broader market multiple. steel companies do tend to react to earnings releases. Picking entry points around earnings releases is therefore a key consideration for investing in steel stocks. while some. as industrial companies with defined plant and equipment. book values are more relevant and the sector historically traded at 1. with a normalised absolute P/FE of 9-11x.
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. and mining companies tend to have extremely detailed earnings releases. and unlike miners. as well as EBITDA down to individual operations in some instances. steel mills tend to be more highly leveraged than the miners. Companies often have a wide range of asset ownership types. and as a result can see significant movements in associates income and minority dividends in the income statement. with EV/EBITDA multiples relatively static through the cycle. as consensus expectations for near-term (and sometimes long-term) commodity prices are dragged up and down by movement in spot prices for commodities. a 10x forward PE seems to work well as a rule of thumb.

some are asset heavy. others shorter-cycle (related to operating expenditure and exploration activity). The main sub-sectors are seismic. floating production and well services. but some are longer-cycle (related to capex). The industry still needs to add new productive capacity equivalent to 5% to 7% of existing production to achieve growth in net capacity of 1% to 2% annually. which has been exacerbated by capacity additions in Asia over the past 18 months. The equity listed structure of the global oilfields services sector is.
Key themes
Access to resources
With growing resource nationalism. long lead times. but it is likely to become increasingly important (as a traded sector) in emerging markets. the refining of oil to produce gasoline. and possibly more for large projects. It normally accounts for around 70% of their value and on average attracts more than 70% of new investments. and the marketing of oil and gas products to consumers. which drive 75% to 80% of earnings. drilling. since existing fields have decline rates of around 3% to 5% annually.com
Upstream is the key value generator – main challenge is to manage access
Integrated international oil companies (IOCs) view upstream as a key value generator. more developed in the Western world. gas transportation (both by pipe and as LNG). The industry is also capital intensive with most material projects involving multi-billion dollar spending. The industry’s reaction has been to reduce capacity through closures (many temporary) and disposals. Annual growth in demand is 1% to 2% for oil and 2% to 3% for gas. Development of this new capacity involves long lead times. One distinction among different parts of the sector is cyclicality. subsea/offshore equipment and construction. Growth tends to be higher in non-OECD regions and can be flat or even negative in parts of the OECD. particularly Latin America and Asia. the refining industry suffers from oversupply.
Oil services
Oilfield services are diverse. capital intensive: The industry is relatively mature. transportation of feedstocks. and drilling. some asset light. The oil-service industry is a large-cap sector in the US and a midcap sector in Europe. companies that have secured acreage in prospective. and is not registered/ qualified pursuant to FINRA regulations
Downstream – oversupply a problem
Following the decline in demand in 2008.spedding@hsbcib. accessible areas of the world (Brazil. both onshore and offshore.com David Phillips* Global Co-Head of Oil and Gas HSBC Bank Plc +44 20 7991 2344 david1.
Low growth. engineering and construction. typically five to ten years from discovery to monetisation.EMEA Equity Research Multi-sector September 2010
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Sector description
The value chain of the Oil and Gas sector includes the extraction of oil and gas. diesel and other petroleum products.
*Employed by a non-US affiliate of HSBC Securities (USA) Inc.phillips@hsbcib. unsurprisingly. supply vessels. It can also include a gas and power division. All areas are cyclical. Integrated players operate across the entire value chain. This can involve power generation and distribution. the US Gulf and East Siberia. The US sector is weighted more towards well services. for example) are likely to have the
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Paul Spedding* Global Co-Head of Oil and Gas HSBC Bank Plc +44 20 7991 6787 paul. West Africa. Independents normally focus on a part of the chain. Oil companies also face tightening fiscal regimes and resource nationalism as host governments seek to maximise their return from oil and gas discoveries. The European sector has a high exposure to capex trends (long cycle) and to offshore activities.

Its supply cut in 2009 helped stabilise the crude price around the USD70 to USD80/bb. is likely to be met from OPEC.
Sector drivers
Realisation and margin are key drivers
For most companies. We believe the accelerating decline rates for non-OPEC production. OPEC’s policy of managing production at a level sufficient to support oil prices damps some of the cyclicality in the upstream. The degree of sensitivity to the oil price varies depending on the type of company. the shorter-cycle service companies and independent exploration companies are more sensitive than the majors.
Prefer refiners in emerging markets than those in developed markets
OECD refiners face flat to declining demand for oil products and the potential impact of carbon pricing.) In our view. particularly deep-water offshore. (We doubt Iraq will achieve its targets because of the security situation and bottlenecks in local oil services. realisation and margins are more important drivers of earnings than growth. For most companies.
Upstream: oil price drivers
At present. Asian and Middle East refineries also often have a cost advantage over OECD players due to scale and lower local costs. The three key levers are oil price. the OPEC target price band of USD70 to USD80/bbl is close to the economic price needed for development of marginal sources of crude oil (Canadian tar sands and deep-water US Gulf discoveries). This tends to favour ‘national’ energy champions. In our view. therefore. It is also low enough to allow global economic growth to continue and so is at an acceptable level for both consumers and producers. that may mean OPEC’s spare capacity could be eroded away by the middle or end of this decade.5MMbbl/d to 3MM to 4MMbbl/d by 2015. Some governments also give their national companies automatic participation in discoveries made by other companies. Those are more pronounced in the downstream than in the upstream.
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. the refining industry in Asia enjoys easy access to growth markets. For example. One country that could ease this potential tightness is Iraq. Middle East refiners have the advantage of cheaper feedstock. mean we may be close to a plateau for production outside OPEC.
Long-term cyclicality
The long lead times in the oil industry mean most of its businesses are at risk of cyclical behaviour. short-term movements in their share prices are correlated with the oil price. in our view. OPEC can also prevent prices rising materially above the top end of its target range if it wants to. We also estimate the price band is below the level needed to support heavy investment in unsubsidised alternative-energy projects. which often get preferential access to exploration acreage. Any incremental demand. The dollar is also a key driver. The IEA forecasts Iraq will increase production from 2. OPEC appears able to exercise control over oil price by limiting production. If Iraq can meet its official plan to ramp up its production to 6MMbbl/d by 2015 and 10MM to 12MMbbl/d by 2017. many of them partly or wholly government-owned.EMEA Equity Research Multi-sector September 2010
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potential for above-sector average growth. greater discipline might be needed from the rest of OPEC to avoid downward pressure on prices. natural gas price and refining margins. Similarly. With OPEC spare capacity of currently around 6MMbbl/d.

sentiment towards the sector is influenced by oil prices and refining margin in the short term. 40% is regulated and only 20% has a direct or indirect link to oil prices (Europe and Asia). EV/DACF multiples). the key is the trend in oil industry capital expenditure. In the medium to long term.
Integrateds – earnings and cash flow multiples
The large integrated players tend to be valued using traditional multiples (PE. around 40% of natural gas is exposed to gas-to-gas competition (primarily the US market). A key variable is the oil price assumed. For the service sector and the independents.
Valuation approaches
There are significant differences in the approaches followed to value integrated large players and small independent players. Currently.) The US could remain a low-price market through rising shale-gas production. Although the proportion of spot sales has increased in Europe. We expect OECD refining profitability to remain weak with Asian and Middle East refiners benefiting most from non-OECD demand growth. West Africa. we believe Europe’s link to oil prices is likely to remain in the medium term. For the balance of the decade. The 2008 recession caused a sharp reduction in gas demand in the OECD. the North Sea. There is therefore the potential for further "capex catch-up". which put downward pressure on spot prices for gas price. EV/NOPAT. we believe the price could remain stable in this band. (We believe this is necessary to ensure security of supply. the Middle East/North Africa and parts of Asia/FSU for opex-related work (ie existing oil-producing areas). Much of the increase in spending during 2006-08 was driven by inflation rather than activity. (HSBC uses a 2010 Brent price of USD75/bbl
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. the trend in sector earnings relative to those for the market tends to drive relative performance. with Saudi Arabia targeting an oil price range of USD70 to USD80/bbl.
Refining – oversupply
We do not expect the current overcapacity to disappear in the next five to 10 years unless large-scale closures take place.
Valuation: equity characteristics and accounting dilemmas
Short-term sentiment
Due to the sector’s dependence on the external environment of realisation and margins. We also believe gas prices in Asia are likely to retain their link to oil prices because of their dependence on imported LNG. but with an increased blend of spot prices. increases in demand will be met from new capacity being added.EMEA Equity Research Multi-sector September 2010
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Gas price – oil price linkage to remain outside the US
Globally. Some analysts use prices related to those on the futures market. and North/South America. we believe. Onshore is driven more by the Middle East and Australasia for capex-related work. corporate activity is also a potential driver. Offshore activity is driven mainly by areas like Brazil. Australasia and the US Gulf (hence concerns following the BP well blowout). That coincided with rising unconventional supplies in the US and the commissioning of several new liquefied natural gas (LNG) schemes during 2009/10. P/CF. others use their own forecasts. mainly in Asia and the Middle East.
Service sector – capex trends the key
For the service sector. but we believe the lack of export facilities makes it unlikely any price pressure will be exported to other markets.

midcycle valuation approaches can be used. For companies with highly cyclical businesses.EMEA Equity Research Multi-sector September 2010
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currently. The price-to-book (P/B) ratio also serves as a useful check to valuation. The long-run PE for the sector is around 80% relative to the market. Unlike with the majors. the multiple approach can involve pre-tax measures (EV/EBIT or EV/EBITA) as tax rates vary less amongst downstream relative to upstream companies. analysts can use a sumof-the-parts approach.
Upstream companies – per barrel valuations or DCF
Upstream companies tend to be valued by deriving a net asset value.
Downstream companies – SOTP and multiples
Downstream companies are normally valued on a multiple or SOTP. size and location. For some of the smaller companies or for those where a restructuring is possible. particularly for companies with significant capital under construction. As with downstream companies. the range of valuation approaches is also diverse. Downstream assets are valued using ‘per barrel’ approaches based on market transaction with adjustments for complexity. Upstream assets tend to be valued using discounted cash flow (DCF) analysis or by using comparable transaction values. For the assetbased companies (such as rig owners).) The most common valuation approach used is PE-based in our view.
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. multiple-based approaches can be pre. Other assets can be valued on a multiple bases – either earnings or cash flow-based – using comparable companies as a reference point. a SOTP is often used with individual assets being valued at replacement cost or by using comparable companies as reference. Exploration assets can be valued on a similar base but with a risk factor to reflect the likelihood of success and the difficulty of commercialisation.
Oil Service – SOTP and multiples
Given the diversity of the service sector. This can involve a DCF valuation of the existing assets or could use a simple ‘per barrel’ valuation of reserves based on comparable companies or recent transactions.and post-tax.

998bn in Europe. The industry can be viewed in the context of ownership. The breakdown of investment by source of capital (see chart) shows that the proportion of public equity (which includes REITs – real estate investment trusts – in the UK) was only 4% of the total or GBP24bn. At various points in the cycle.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. Property yields represent the ratio of a property’s annual rental value to its real estate value. REITs (and their European equivalents) were invented to enable investment in property via a vehicle offering much greater liquidity than direct property (real estate itself). EUR410bn in France and EUR451bn in Germany. Insurance companies and banks are the largest owners of private debt and private equity invested in the sector as commercial property has traditionally met their need for asset diversification. In Europe. EUR629bn was in the UK.9 trillion at the end of 2009 with a total EUR2. lower liquidity and a less transparent valuation network are reflected in lower volatility of capitalisation rates.
Nicolas Lyle* Analyst HSBC Bank Plc +44 20 7992 1823 nicolas. Of that.lyle@hsbcib. of attracting new sources of capital into the sector. current personal taxation favours capital gains over income. In the UK.EMEA Equity Research Multi-sector September 2010
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Sector description
Property’s place in the economy
The primary purpose of property companies is to provide accommodation to businesses and households. REITs in the UK have adopted a total return strategy. therefore. and therefore market pricing is more focused on income returns. The key driver of pricing the assets in the industry is rental growth expectations. according to DTZ in its Money into Property report (May 2010). The European public equity market (excluding Nordics and Switzerland) is approximately EUR58bn according to EPRA (European Public Real estate Association) with the key difference being less liquidity due to lower levels of free float. which is representative of the market capitalisation of the FTSE 350 real estate index. which aims to deliver income returns (through asset management strategies) and capital growth (via development projects). and is not registered/ qualified pursuant to FINRA regulations
Europe (ex-UK) invested stock by source of capital 2009
UK invested stock by source of capital 2009
Priv ate equity 32% Priv ate debt Public equity 4% Public debt 16%
Source: DTZ Source: DTZ
Private equity 27%
48%
Public equity 4% Public debt 17%
Private debt 52%
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. but the same effective tax treatment with the added possibility. which are derived from imbalances between tenant demand and property supply. reflecting the cyclicality of the economy. and the attraction for investors also depends on the tax treatment of capital gains and income. ie the kind of entity that owns the real estate. The amount of money invested in commercial property globally was USD10. the emphasis on the different parts of the strategy will vary.

40% at the height of the boom. As a result. technological improvements and flexible ways of working.
Bank de-leveraging
The property boom of 2003-2007 has led to a record level of bank debt secured against UK commercial property. leading to market share gains for the national retailers but reducing overall demand for retail space. This gradual reduction in exposure to loans secured by commercial property assets is likely to restrict the availability of (debt) capital to the sector for many years to come. This trend has been accelerated by the credit crisis and ongoing downturn. significant numbers of loans are in breach of covenants. In the UK. sending rental values into freefall. a key differentiator of the UK commercial property market from the market in continental Europe was the security of income brought about by the relatively long (and unbroken) lease lengths of 25 years in London offices and 15 years in the retail sector.EMEA Equity Research Multi-sector September 2010
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Key themes
Late in the cycle returns
The availability and cost of debt capital determine the size of the investment pool. with an increasing trend among national retailers to open flagship stores in fewer but higher-footfall locations. The corollary is that inadequately financed retailers with declining brands have been forced into liquidation. respectively.2 years. The all property equivalent yield (as measured by the UK investment property databank) fell by 250bps to a trough value of just under 5. combined with the internet have eroded the value of physical premises as a central workplace or to store goods. where occupancy costs are lower and access is more convenient for car users. This has been accompanied by a gradual shift from high streets to edge of town retail parks.
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. vacancy rates across town centres and in secondary quality shopping centres rose to historic highs in the last three years. As a result. The investment boom left over-leveraged bank balance sheets over-exposed to the sector. As in the 1990s credit crisis. representing just over 11% of participating banks’ total lending at the end of 2009 compared with 10% at the height of the last credit crisis in the UK in the early 1990s.8 and 10. As a result. lease lengths are getting shorter with an increasing proportion of leases carrying clauses that give tenants the option to break the lease every five years.30%. The BPF/IPD annual lease length survey reported that average lease lengths in UK shopping centres and central London offices (for post-1990 leases) are 10. with industry estimates of GBP50bn in negative equity. REITs had also over-leveraged themselves in this period and the majority had to resort to rescue rights issues in 2009 as property prices fell beyond expectations and threatened breaches of loan covenants. The Bank of England reports just under GBP250bn of outstanding debt. In the last decade. Conversely. the near freezing of debt capital in the months around the Lehman Brothers bank collapse in September 2008 caused the greatest fall in property prices in the post-war period with the all property equivalent yield rising just under 400bps to a peak value of 9. This was the key driver of the listed sector’s tripling in value between 2003 and 2007.
Structural decline of income security
Historically. RBS and Lloyds Banking Group together represent approximately 38% of the GBP250bn market and both have publicly committed to reducing their exposure to non-core property loans. as can be seen in the chart above. causing a 45% fall in capital values over the two years to June 2009.
Retail consolidation
The internet has been a key driver of retailers’ reduced need for physical space in the UK.

and if supply exceeds demand the reverse is true. exacerbated by historically high levels of available space in secondary locations. implying greater volatility of returns. current lease income on many property portfolios is above market values. Sustainable income returns and the potential for rental growth are therefore very important to overall returns. Occupier demand is the key driver of portfolio vacancy rates and therefore rental growth potential. A strong global and domestic economy fuelled five years of continuous rental growth to 2008 which was a key driver behind the surge in property company NAVs. prime rents have fallen 20-50% on a net effective basis since the onset of the crisis. in the UK at the end of 2009. Further. just under 70% of capital invested into the sector (private and public) was debt capital. and as a result the sector is late cycle (owing to the time it takes to ‘renew’ the rent roll as leases expire).
Availability of debt financing
Debt capital is the lifeblood of liquid property investment markets.
Sector drivers
The listed vs the direct market
REITs share prices (and those of listed property companies) are sensitive to global capital flow imbalances and macroeconomic conditions.EMEA Equity Research Multi-sector September 2010
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Over-renting
In the UK. Rental growth is the principal driver of property returns over the long term. and so they face a significant reduction of rental income when the current leases expire and new leases are negotiated. In times of economic expansion. although this is compensated in part by the greater liquidity and transparency of share trading. limiting the choice and availability of accommodation. The relatively large lot size of individual assets and the limited opportunities for raising returns on a standard investment with a long lease imply that debt capital is an appropriate source of finance for commercial property investment. The listed sector is also more affected by wider market sentiment. and comes either from the banks or the capital markets (bonds to CMBS). This reduction in income will take time to unwind. An absence of economies of scale and low barriers to entry compounds the weakness of a capital-intensive industry. rents rise and capitalisation rates (yields) fall. placing the sector squarely in the ‘value’ category (rather than in ‘growth’). As a result. Reflecting this. the REIT regime (which requires the payout of 90% of eligible rental income) limits the retention and re-investment of capital. especially in a capital-constrained economy.
Rental growth
Rental value growth is a fundamental driver of property prices as investors determine an acceptable capitalisation rate for rental income projections. However.
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. Consequently. many property companies and some REITs are likely to see underlying net rental income falter between 2010 and 2012. tenants’ space requirements increase and drive up occupancy rates to high levels. and will reduce free cash flow growth and constrain commercial property landlords’ ability to grow earnings. when a tenant needs to move or to expand and property supply does not increase to match these needs. as leases expire on over-rented property (where the passing rent exceeds the value of the market rent).

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. As a result. timing differences exist between the income and cash rents receivable in any given year.
Income spreading
The main accounting adjustment that REITs have to make under IAS 17 (SIC 15) is to account for lease incentives (mostly rent-free periods and capital contributions) as an integral part of the consideration for a leased asset. either due to an excess supply of investable assets. amortising on a straight-line basis. a lack of transparent and liquid markets or lack of investor interest. these are capitalised and accounted for as a deduction of cash rents.EMEA Equity Research Multi-sector September 2010
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Leading indicators
Investment market
 Redemption yield on benchmark 10-year gilts  Five-year swap rate  Bank margins  Banks’ capital ratios. over the life of the lease in line with accounting for net rental income. with the income account notably higher than the cash account in the early years of a lease (especially in recession when rent-free periods comprise a greater portion of net rental income). As a result. adjusted for fair value. rent-free periods are minimal and therefore the gap between the income and cash accounts is minimal. The valuation premium or discount to book value represents how investors expect property capital values to change either through rental or capitalisation yield changes. In a benign economic environment. The difference between adjusted NAV and ‘triple net NAV’ or ‘NNNAV’ principally reflects the reversal of mark-tomarket movements on the debt and derivatives (included in the adjusted NAV) and the deduction of deferred tax provisions (in respect of latent capital gains). the cash rent roll begins to overtake the income account. (In most European countries. NNNAV should represent the fair value of the equity and includes fair value adjustments of all material balance sheet items which are not reported at their fair value as part of the NAV per IFRS balance sheet statements.) Adjusted NAV represents the difference between the value of the company’s assets (as estimated by independent appraisers) and the total sum of its debts or liabilities. referred to as discount/premium to adjusted net asset value (NAV). As a result. As rent-free periods come to an end. CMBS issuance
Occupier market
 Employment indicators  Vacancy rates  Development pipelines and space absorption rates  Tenant incentive levels
Valuation: equity characteristics and accounting dilemmas
NAV and NNNAV
The traditional valuation measure for European REITs is price/book ratio. reflecting the headline rental value achieved on leasing. Where capital growth cycles are less pronounced. the valuation discount/premium is to the ‘triple net NAV’ or ‘NNNAV’ [see below] due to differences in holding structures such that transfer tax becomes relevant. a pure DCF valuation methodology may be more appropriate because each investor can determine the required rate of return.

and so the key lead indicators for sales and earnings growth performance can differ markedly between companies. the two major European stocks. Furthermore. is varied in nature with no two companies the same. limiting investment opportunities. is arguably the only area of structural growth
Paul Rossington* Analyst HSBC Bank Plc +44 20 7991 6734 paul.rossington@hsbcib. with one or more of the following characteristics:  Specialist proposition with limited exposure to supermarket competition. Although consumer confidence has staged a marked recovery since the beginning of 2009 (from historically low levels). the listed component is typically asset-light. Inflation is good for the sector as it helps the top line and the bottom line for those who have pricing power. We give some examples on the next page. the general election and emergency budget.EMEA Equity Research Multi-sector September 2010
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Sector description
General retail
The UK general retail sector is highly cyclical and a largely mature industry (70% organised retail penetration) with few genuine defensive propositions and limited international revenue exposure. an increase in savings rate means less consumer spending with a knock-on effect on GDP and household income. owing to substantial private equity investment between 2002 and 2007. Although lower interest rates help support or encourage consumer spending and confidence. the recent problems in Greece and Eurozone debt worries and. attracted by strong cash generation. except perhaps for the ‘value-based’ propositions (eg fashion).
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. specifically for the UK. a significant proportion of the industry is now in private hands.
Company sales indicators
Although the vast majority of companies in the sector are cyclical by nature. Base rates have a strong positive correlation with retail sector performance.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. and premised on the availability of cheap debt finance and sale-and-leaseback freehold property assets. The four FTSE 100 companies account for c65% of this total. and has a combined market capitalisation of just cGBP24bn. Where growth propositions do exist in this sector they are typically small/midcap companies. interest rates and inflation
In most consumption-driven economies (like the UK) the unemployment rate has a very strong correlation with the GDP growth rate. Accordingly. consumer confidence is a key lead indicator of the retail sector’s performance. This compares with the cGBP62bn combined market capitalisation of Inditex and H&M. or the ability to adapt to. We note UK consumer confidence is also closely correlated with that of the US. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Sector drivers and sales indicators
Macro drivers: unemployment. no two companies are the same. Thereafter the savings rate (the percentage of disposable income that is not spent) is the single largest determinant of future household disposable income. savings ratio. it is rising interest rates and by implication the improving outlook for GDP growth that drives longer-term sector performance. the internet and online consumer spending pattern which. have reduced consumer confidence.  Percentage of revenues from international and emerging markets  Exposure to.
Consumer confidence
In the short term.

This trend has now reversed. was as good a result as UK general retailers could have hoped for. this remains an area of structural growth. thus offsetting the cumulative impact of a 13% increase in input costs.
Input cost pressures
European retail has for the last 10 years been a major beneficiary of the USD carry trade. a large proportion of which are sourced via the local agents of major branded manufacturers based in the Far East thus underlying exposure to rising input cost pressures is greater higher than the directly sourced Far East CoGS would suggest. the cessation of dividend payments. these companies are now better positioned to benefit from increased operational gearing. all numbers are approximate
Cost-cutting and cash-saving initiatives
Aggressive cost-cutting initiatives have characterised all but a handful of operators in the sector. Chinese labour and freight costs. Accordingly. company data. are under most pressure on cash gross profits and gross margins. as companies can re-price on the introduction of their Spring ranges after Christmas. Source: HSBC. and imposition where applicable of higher VAT. By reducing or optimising what are largely fixed-cost overheads. Our analysis suggests that in the absence of volume growth. followed by those with greatest exposure to GBP/EURdenominated revenue streams. Although it is not yet clear what the level of online penetration (currently 8% of total UK retail sales) in specific categories will ultimately be. Those retailers sourcing predominantly in dollars out of the Far East (but deriving the vast bulk of their revenues in euros) will see cash gross profits come under pressure as a result of rising raw material. and ultimately EBIT margins.EMEA Equity Research Multi-sector September 2010
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Structural shift – the internet and supermarket operators
With the rollout of broadband networks.5% not coming into effect until 4 January 2011. **Refers to Marks and Spencer General Merchandise sales only. six months after the rise was announced. increasingly sophisticated website innovation and certain product categories being suitable for digital dissemination (eg entertainment). the internet poses a material competitive threat to some established bricks-and-mortar business models that are already under pressure from an intensification in non-food competition from the major supermarket groups. the relaxation of covenants in the short term. and equity capital raisings (rights issues) have been used to restore the balance sheets of those companies with sustainable business models. as well as strength in the dollar and gradual appreciation of the Chinese renminbi. We consider that most successful models will be either pure-play internet or genuine multi-channel retailers.
Major retailers: proportion of direct Far East/USD-sourced CoGS and respective GBP/EUR revenue exposure Company Far East/USD sourced CoGS EUR/GBP revenues Company Far East/USD sourced CoGS EUR/GBP revenues
Home Retail Group* Hennes & Mauritz Inditex
35% 65% 35%
100% 85% 60%
Kingfisher Marks & Spencer** Next
20% 50% 80%
80% 100% 100%
Note: *Home Retail Group derives >50% of revenues from electrical goods.
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. the companies with the highest exposure to Far East/USD-sourced products. a weak USD and the switch to lower-cost Far East sourcing underpinning gross margin expansion. It minimises implementation costs. Where balance sheets have been stretched beyond covenant limits. but is a substantial growth opportunity for others.
VAT
The increase in UK VAT to 20% from 17. reduced capital expenditure. the retail selling prices of products sourced in the Far East need to rise by c6% for cash profits to stand still. while providing a six-month window in which to identify the best way to pass on the increase through higher prices and also to switch or renegotiate supply contracts.

capacity withdrawal and M&A
In recent recessionary times the retail sector has been characterised by capacity withdrawal with highly leveraged private equity (eg MFI Group) and listed (eg Woolworths) businesses failing alike. Mothercare) typically trade at a premium to UK-centric business models. UK-centric business models and thus low earnings growth rates. because of their largely mature status. Defensive stocks typically trade at a discount to the sector but are often characterised by higher FCF/dividend yields supported by consistent and sustainable cash generation. structurally challenged business models leading to a short-term collapse in profitability. Hennes & Mauritz. UK-centric vs international: Those stocks which offer international diversification (Kingfisher. The vast majority of sector casualties have been smaller in nature and characterised by overexpansion in previous years.0x with an average of 13. Although capacity withdrawal has been mitigated by the pre-pack administration/CVA process. often characterised by companies with emerging competitive advantages via scale in specialist retail categories.EMEA Equity Research Multi-sector September 2010
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Consolidation. Additionally. EV/EBITDA. client data in the case of internet-based operators) at depressed valuations. remain the key metrics by which the sector is most often screened or filtered.1x. and supplementing PER analysis.2x to 17. ROIC is often seen as a key measure of performance for mature companies. supported by a structural growth dynamic (eg the internet) or cyclical recovery. Cyclical stocks typically trade at a premium to the sector and can often deliver high or super-normal earnings growth.
Classification
Cyclical vs defensive: Stocks can be classified as cyclical and defensive names as well as those offering international diversification or genuine growth potential. and management’s wide use of them. it is the larger companies within the sector that stand to gain most from reduced competition either via market share gains or the acquisition of distressed assets (these could be complementary brands. PER. reliability and surety of underlying cash flows. although accurate in assessing the present value of future cash flows by absolute quantum (subject to realistic underlying earnings assumptions). At the end of August 2010 it was c10x. Intrinsic valuations methodologies such as discounted cash flow (DCF). dividend discount model (DDM) adjusted present value (APV). with exposure to emerging markets and BRIC territories highly valued by the investor. often operating in price-led commodity categories. both free cash flow (FCF) and dividend. the PER is generally considered to be the key long-term metric by which the sector is valued. typically trade at a discount to other UK FTSE350 General retailers. Inditex. and yield. excessive leverage. The 10-year historic one-year forward PE range is 7. physical assets. With debt concerns largely removed from the valuation agenda. fail to reflect the quality.
Accounting dilemmas
The proposed inclusion of off-balance sheet operating leases (essentially future rent liabilities attached to retail stores) under IFRS accounting rules could negatively impact the perceived valuations of those companies that do not screen well under this metric.
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. FTSE100 vs FTSE350: FTSE100 stocks.
Valuation: equity classification and accounting dilemmas
Key valuation metrics
In the case of the retail sector.

dargnies@hsbc. where much of the production for sporting goods is done locally and some consumers may not be able to afford or be willing to purchase the higher-priced Western goods. Although most apparel and footwear developed by these companies was initially designed to actually practise a given sport.com Sophie Dargnies* Analyst HSBC Bank Plc. for instance. their main focus is still their domestic market in the US for the time being. market. running. many local companies.  Lifestyle companies: one of the problems when defining the sector is that consumers are much more volatile than before and open to buying sporting goods as a lifestyle statement. Callaway. produce. In China. Private-label brands.
US athletic footwear market shares (total: cUSD12bn) 2009 Global athletic footwear market shares (total: cUSD33bn) 2009
Erwan Rambourg* Analyst HSBC Bank Plc +44 20 7991 6793 erwan. have diversified their reach. the sector is broadly challenged by any company that manufactures sneakers or casual apparel. cricket. Paris branch +33 1 56 52 43 47 antoine. such as LiNing and Anta.  Local players: some sporting goods companies have a more local reach. for instance.belge@hsbc.rambourg@hsbcib.EMEA Equity Research Multi-sector September 2010
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Sector description
The Sporting Goods sector includes companies that develop. from the very broad football (soccer). and is not registered/ qualified pursuant to FINRA regulations
Other ASICS 4% Reebok 4% VF Corp 5% adidas 6%
Source: SGI
Other
Nike 34%
22%
24%
Nike 30%
Reebok 4% New Balance 4% Skechers
Skechers New Balance 7% Conv erse 9%
Source: SGI
4% Puma 6% ASICS 6% Conv erse 7%
adidas 15%
9%
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. Nike. Some companies are invested almost exclusively in golf – for example Titleist. Europe HSBC Bank Plc. have become big successes. casual wear (Lacoste and Diesel) or vertically integrated retailers (eg Uniqlo). the consumer trend of wearing sporting goods products on evenings or weekends just for the look has gradually blurred the boundaries between athletic and lifestyle products. be it in luxury (eg Christian Dior and Louis Vuitton). Consequently. footwear and/or accessories (hardware such as golf clubs. such as those developed by French distributor Décathlon. basketball and tennis product categories to the more regional or specialised categories like baseball. distribute and sell athletic apparel.com Antoine Belge* Head of Consumer Brands and Retail Equity Research.  Niche/specialised players: some companies have developed an edge/specialty in a given subsector of the industry. footballs and fragrances). sells from California to Tokyo and caters to athletes in most sports. companies like Babolat and Head have dedicated much of their development to hardware (the actual racquets).com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. American football and action sports. Mizuno. skis and training machines but also watches. In racquet sports. Although UnderArmour (originally grassroots American Football) and lululemon. the world leader in the sector. for instance. Paris branch +33 1 56 52 43 48 sophie. are limited in reach by the distributor’s regional exposure.  Global players: a few companies (those we cover and a few others like Asics and New Balance) have a global footprint and a highly diversified portfolio of products.

it is key for them to find ways of expanding/maintaining their gross margin and containing operating expenses other than advertising and sponsorship costs. where margins are already currently higher than in the US – still the leading market for the sector. as the major players (Nike. we expect that one of the key drivers beyond these two will be gaining access to higher-growth countries and developing leadership positions there.  Advertising and sponsorship deals – one approach to the sector is to look at the inflation in advertising and sponsorship deals. and any strength of the USD is a negative for both European players and Nike. too. In future. adidas) have considerable marketing and advertising clout. even on technology-driven products.EMEA Equity Research Multi-sector September 2010
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Key themes
The difficulty of defining the boundaries of the sector itself means that the issue of barriers to entry is of key importance for the companies that operate in Sporting Goods. price and brands).  Currency fluctuations – since much is produced in countries with USD-related currencies (and often negotiated in USD). not investors. On the performance side alone.  Increasing retail exposure – as a way of controlling their brand image (avoiding tough discounting from distributors) and enhancing their gross margins.  Commoditisation risk – with new entrants every year and the increasing credibility of private label. leather and fabric). ensuring that they can lock in the key sponsorship deals with high-profile teams (football clubs and national Olympics teams) and athletes (NBA. This pressure on costs could lead to the belief that “big is beautiful” within Sporting Goods – or at least oblige small brands to be nimble if they are to establish a worthwhile business model. Although the macro environments may influence the cost of goods sold (via the prices of oil and oil derivatives. We believe that the key concerns/themes for the Sporting Goods industry are:  Production cost pressures – an important part of production for Sporting Goods takes places in South-East Asia – most notably mainland China. pricing power in the sector may turn out to be a long-term issue. golf stars and football stars). a brand’s capacity to outspend its competitors is a key sales driver. we nonetheless believe Chinese wages are likely to increase structurally over the long term. barriers to entry appear more limited although there. looks. possibly creating a perception that the value is going to athletes. many brands have entered into comprehensive own retail strategies. we believe own retail makes sense for the more lifestyle-driven products. barriers to entry are high.
Sector drivers
The Sporting Goods sector has been driven by sector-specific events: big events like FIFA World Cups or Olympic Games that can drive sales while increasing marketing spend and also M&A events that have gradually reshaped the competitive landscape. any weakness in the USD against a basket of currencies (notably the EUR) is a positive for the sector. To make sure that inflation in ad spend and sponsorship costs does not hamper the long-term margin profile of these companies. Although we believe the space for performance products should still be dominated by wholesale (eg consumers will want to compare technology. ATP Tennis.
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. In the lifestyle part of the business. whose costs appear to be consistently rising as a percentage of sales. obliging companies in the sector to find ways of offsetting the resulting pressures.

As illustrated earlier in this section (see graph. in a rather narrow range. Market share battles should now focus on higher-growth.EMEA Equity Research Multi-sector September 2010
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 Sports events – Sporting Goods is characterised by ‘on years’ and ‘off years’. and typically reflect the state of the economic. to a certain extent. On the other hand.
Valuation: equity characteristics and accounting dilemmas
As companies in the Sporting Goods sector tend to not be very capital/debt-intensive. its market shares have increased consistently and its history of acquisitions is more reassuring than those of peers (look at how Converse soared and how Umbro issues were rapidly addressed). although during the downturn the stock was seen as a debt-free safe haven. Although some events both bring a strong boost on sales and imply large advertising investments (World Cup). Cash management has been an issue for several years now at Nike. Historical PE valuation of the Sporting Goods industry). 2012).to mid-teen 2011 PEs. Umbro and Hurley) and the adidas group (adidas. 2010 and 2014) or by both the UEFA Football Euro and the Olympic Games (eg 2008. market and consumer environment. the companies have traded. The on years are all the even years when the sector is moved either by the FIFA World Cup (eg 2006. it is also structurally less profitable than others (at least in terms of gross margin) as the products have. higher-margin regions including China. the sector has been very active in terms of consolidation. Converse. although we now believe the main issue for the sector as a whole is cash re-investment rather than debt management.  M&A and cash management – as advertising/sponsorship costs inflate. we also think that mounting uncertainties regarding 2011 (especially on the cost side) have made the market less enthusiastic about paying above-average multiples now that the big event for 2010 (World Cup) is behind us.  Geographic diversification – although the US remains the largest market by far. the companies are trading at low. has a leadership position and very strong cash levels. The adidas stock has been the exception for a few years following the difficult integration of the Reebok brand (acquired in December 2005). relatively in line with or very slightly below the mid-teen historical forward multiple averages. entailing high costs but fairly limited event-related sales. Currently. they generally trade on forward-looking price/earnings ratios.
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. on average. There are several reasons that might explain why Nike has historically traded at a premium to its European counterparts: it is listed in the US. We expect that restructuring measures taken throughout the sector in 2009 and the strong beginning to 2010 (excluding Puma) galvanised EPS. Nike Inc (Nike. Reebok and TaylorMade) have been among the bigger players in this respect. others (typically the Olympics) are more akin to a PR event. been commoditised there.

Sector description
The Telecoms, Media and Technology (TMT) sector encompasses a wide range of sub-sectors. Telecom sector: The telecoms operators work on two different platforms, fixed line and mobile, and sell raw connectivity (eg line rental and broadband) and services (eg voice and IPTV). Media sector: The media sector brings together a large range of business models; some are advertising-related, others not; some mostly local, others global; some suffer and some benefit from the audience fragmentation due to digital media, some are more capital-intensive than others. Traditional sub-segments are pay-TV and free-TV, communication agencies (together with market research), publishers and internet-related players. Satellite operators (fixed and mobile satellite service) and cable operators are linked to both media and telecom. Technology sector: The technology sector is also fragmented and diverse. However, for ease of understanding, we have divided the sector into four sub-sectors: telecom network equipment vendors, software and services, original equipment manufacturers and foundries. The entry barrier in the telecoms space is intrinsically very high, given that each market is dominated by three to four key players and scale is the key determinant of success. However, regulators have attempted to undermine these natural barriers to entry by intervening with remedies like unbundling the local loop so as to promote market entry. In the media space, the need to have the use of a distribution platform (like satellite) has been a powerful barrier to entry, but in future we believe that viewers will increasingly turn to broadband internet links to receive their video content (eg via the BBC’s iPlayer or Google’s YouTube). This will open up the media market to a broader range of names, in particular to internet and telephony brands. Telecom and media are coming together – converging in some instances and colliding in others. Telecom service providers have entered not only the media sector with TV offerings, but also the technology sector, with a host of applications. On the media side, cable/satellite TV operators are vying for telecom customers through converged service offerings of voice and broadband along with TV. Standalone satellite operators, which have traditionally relied on capacity leasing for revenues, are now becoming more ambitious, and are entering the telecom space, aiming to offer broadband services using the terrestrial and satellite networks. In the technology sector, device/hardware manufacturers, such as Apple have had some success in software. Mobile device/chip manufacturers, such as Qualcomm, have also displayed interest in the mobile services business. Overall, we believe the collision between the sectors will favour multi-play providers over single-play competitors, not only from a customer perspective (bundling, cross-selling and churn prevention), but also from a network cost perspective, as backbone and backhaul capacities can be shared. We therefore expect mobileonly players to increasingly seek to add fixed-line capabilities – as Vodafone attempted to do in 2007 by acquiring Tele2’s operations in Italy and Spain. We also expect integrated telcos to look to expand their content provision capabilities by, say, acquiring football tournament rights or even small content/application companies. Consequently, we expect the purpose of M&A in TMT to shift towards building a cross-sector presence in an individual market from creating a cross-country presence (although the appeal of adding exposure to emerging market growth will continue to drive acquisitions).

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

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EMEA Equity Research Multi-sector September 2010

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Key themes
Scale and capex important; multi-play and NGA likely drivers
As the TMT sectors converge, the service providers are expanding their capabilities (organically or via acquisition) to market themselves as a one-stop destination for all telecom, media and software services for residential and business customers. We believe this shift provides new growth opportunities for service providers while cutting the overall cost of services for consumers. We expect the multi-play phenomenon to continue, and forecast that operators pursuing the strategy of investing and expanding their portfolios stand to benefit. Cable companies (eg Virgin Media) have so far been the main beneficiaries of the multi-play trend, as their network upgrades were easier to achieve. For fixed-line telecoms operators (usually the incumbents), we believe the pace of next-generation access (NGA) fibre network deployment (with FTTN/VDSL or FTTP) is the key to success, as this upgrade greatly enhances the bandwidth and range of services it is possible to offer. One key result of the upgrade is that it is likely to change the competitive landscape. At present many incumbents find themselves out-competed by unbundlers that have bought the use of the incumbent’s existing copper infrastructure to offer their broadband ADSL services. Although we would expect regulators to insist on unbundling being extended to NGA platforms as well, the fact is that it is intrinsically very expensive (as the unbundler has to install its equipment in many more locations for it to work, and this necessitates a very much higher capex bill). As a consequence, we think that most competitors will have to purchase a wholesale service from the incumbent (which they will then resell to their customers); and the returns on providing a wholesale fibre service will be much more attractive to the incumbent than the returns it generates on unbundled copper.

Data explosion, capacity crunch and capex
The proliferation of smartphones and laptop cards has led to rapid growth in mobile data revenues, but has also started to put pressure on mobile networks. A key question for telecom service providers is whether they will need to buy more equipment from vendors (eg Ericsson). Some argue that operators will not have to do so, because improved technology (like LTE) will come to their rescue. However, our research shows that LTE upgrades will boost capacity from the levels provided by today’s 3G systems by only around 30% on a likefor-like basis. We therefore believe that mobile capex will have to rise over the next few years to meet the increase in network demand arising from data growth – and we would expect telecoms equipment vendors to be the key beneficiary. The mobile telecoms operators have done a very poor job, in our view, of monetising the application layer, an area that has been seized by Apple and its app store. However, we believe that the operators can still monetise the raw connectivity provided by their mobile networks, because the very limitations that are becoming apparent in the amount of capacity that technologies like LTE can support will mean that capacity will be intrinsically scarce – and this scarcity should result in pricing power. This is evidenced by the wide range of operators (eg AT&T, KPN) that have now introduced tiered data plans.

New media
As the reach of the internet widens with increasing fixed-line and mobile broadband penetration, digital is being hailed as the new growth frontier for advertising agencies. The emergence of online advertising, which creates new advertising space without incremental demand, is causing fears of deflation in media prices. Media owners (such as television channel owners and newspaper publishers) are already beginning to feel the

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we stress that the relatively high margins seen in the telecom sector mean that. and (3) improved packaging and marketing of data offerings. (2) increased penetration of data-optimised devices. The professional publishers are typically conglomerates with multiple areas of business eg trade shows. there are pay-TV operators. and operators that upgrade to the new technology early can enjoy competitive advantages over the laggards (but are also often exposed to the practical problems that inevitably accompany new technologies). satellite operators and professional publishers whose growth is mainly driven by consumer and service take-up and who generate the majority of their revenues from subscriptions whereas free-to-air TV operators. Data services have recently been the key growth driver for mobile revenues. Technology cycles (and upgrades) influence the capex intensity of the industry. academic publications. as the regulators decide the number of licences to be issued and set the level of many tariffs (in particular. profits and cash flows are relatively defensive in nature. while revenues are tightly linked to the economy. market research and outdoor rely predominantly upon marketing expenditure (mostly advertising). The three main enablers that we think are underpinning the demand for data services are: (1) better network speed and coverage. the regulators set mobile termination rates (MTR) and roaming tariffs. Developed market operators often therefore look to buy exposure to emerging markets. as they must otherwise rely on growth in new services (eg IPTV or mobile broadband) to drive revenues. On the mobile side. which have a material impact on mobile revenues and EBITDA. including the affordability and availability of services. The level of penetration (fixed. in turn. Although penetration levels have generally reached very high levels in the developed markets.
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. IT contracts) exhibit greater cyclicality. newswires.
Media
Media is a heterogeneous sector which lends itself more to stock-picking than to top-down sector-based analysis. so we see considerable potential. those relating to unbundling). However. The increasing number of TV channels and websites has caused audiences to fragment. It is one of the main drivers in determining competitive intensity. Regulation also plays a very important role. specialist trade publications. conferences.EMEA Equity Research Multi-sector September 2010
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pressure. The economic environment also has an impact on the telecom sector. much demand in emerging markets remains untapped. although the sector is not highly geared to the economy. communication agencies. on the one hand.
Sector drivers
Telecoms
The telecoms industry is subject to many drivers. and we expect this trend to continue. while enterprise revenues (eg roaming. like smartphones. only a few of which overlap which hinders sector generalisations. it is clearly influenced by economic and business cycles. making them harder for advertisers to reach and introducing more competition for media owners. the rate of technological innovation (Moore’s Law exerts a particularly powerful influence) and the extent of regulatory intervention. And note that. consumer publishers. Consumer spending is usually less cyclical. mobile and broadband) is a basic driver for telecom services and is. The penetration of smartphones is still quite low (c15% in Europe at the end of Q1 2010). driven by the availability and affordability of services.

respectively). and capital intensity varies according to the platform (eg cable TV is much more capital-intensive than satellite TV). Most of the incumbent telcos have dividend yields greater than those of sovereign bonds. The incumbent telecoms operators have large numbers of employees and thus large pension funds for some. and GDP growth. Unfortunately. some governments over-regulate or impose restrictions on operators.EMEA Equity Research Multi-sector September 2010
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All pay-TV operators are more defensive in terms of their revenue-generating abilities during a downturn than are free to air TV operators or advertising agencies. in the developed countries.
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. Top-line momentum. against c17x for the emerging market players. due to higher growth potential.
Technology
The technology sector is highly heterogeneous. Only outdoor players are developing a media that is fully advertising-related with a business model that can be duplicated everywhere in the world (and catching growth opportunities in emerging areas). In many of the emerging markets. For the telecoms equipment vendors. although emerging market players continue to command a premium. as well as from other types of media (eg if advertisers shift money from radio to TV). we are cautious about inventory/capacity build-ups and/or slowdowns in the order book. are also considered useful. Given the cyclical nature of the foundries business. directories and newspapers) are typically local businesses usually wholly exposed to their domestic economies. ASPs (determined by technological advance and the level of competition) and shipments to assess the likely trajectory of the top line. EBITDA margins and FCF generation ability each play a critical role in driving the stocks. Emerging market players and developed market companies with significant emerging market exposure enjoy higher multiples. The telecoms sector’s trading multiples have deteriorated over the last few years owing to general market weakness. Spectrum costs are lumpy in nature and can take a substantial bite out of operators’ FCF. such as the forward-looking price-toearnings and EV/EBITDA ratios. we focus on the factors driving the operators’ capex lines. especially for foreign players. Note that they are often excluded from clean FCF forecasts. Over 2005-07. Revenue growth is driven by market share gains from competitors. investors focus on the free cash flow (FCF) yield and dividend yield. and lower sector’s growth. like those of BT Group and Portugal Telecom. Traditional relative valuation metrics. both developed and emerging market PEs have fallen (to 11x and 14x. Since telecoms is considered to be of strategic importance. the magnitude and timing of spectrum costs are inherently difficult to predict. we focus on the capacity utilisation rate. Media groups are mostly asset-light. In addition. Over 2008-10. can be very large – and so become an important valuation driver.Among the purely advertising-driven groups. the communications agencies and market research are global businesses with high exposure to emerging markets (typically 25% of revenues) whereas the media owners (eg TV. The deficits of some of these funds. while for the foundries. the average trading PE multiple for the developed market telecom players was 14x. regulatory/political risk is significant. since top-line growth is usually muted. radio.
Valuation: equity characteristics and accounting dilemmas
Discounted cash flow (DCF) methodology is the most traditional method to value companies in the telecom and media sectors.

airports have a free hand to decide their strategy and fees in these segments. network airlines such as Lufthansa and Air France-KLM have other operations. and is not registered/ qualified pursuant to FINRA regulations
Airports and toll roads
Toll road companies provide infrastructure to enable transportation.EMEA Equity Research Multi-sector September 2010
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Sector description
The global transport sector comprises a number of sub-sectors.thomas@hsbcib. which include MRO (Maintenance. freight forwarding (heavy freight carried in air freight and sea freight containers). Low-cost airlines operate on a ‘low cost-low fare’ model. The network carriers also often have large cargo operations. parcels and mail. New projects acquisition is a key strategy in this sector. which generally operate intra-regional networks. Go-Ahead. Together these companies run most of the 20 UK rail franchises and control c75% of the provincial bus market. Typically activities are segmented into: small parcel express (up to 68kg). logistics and shipping. build. hub attractiveness and international travellers’ portfolio can determine growth potential. Stagecoach and National Express operate in largely deregulated markets outside London. The infrastructure operators derive revenues from user tolls fees and hence depend on traffic and tariff fee levels. IT services and catering services. Logistics refers generally to the carriage of freight.com Joe Thomas* Analyst HSBC Bank Plc +44 20 7992 3618 joe. operate and maintain the projects.
*Employed by a non-US affiliate of HSBC Securities (USA) Inc.byde@hsbcib.
UK bus and rail sector (land passenger transport)
The sector comprises four London-listed companies and Arriva (recently acquired). Primarily. Overall.
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. Traffic is driven by economic activity while tariff increases are set through negotiations with the government. with revenue correlated with industrial production. Airport businesses derive revenues from aviation. and low-cost carriers. road network freight operations (eg co-ordination and carriage of less-than-truckload freight shipments. use a single-type aircraft and secondary airports.com
Airlines
Airlines is a highly cyclical global sector. European governments have disinvested their interests in such huge projects by partnering with private companies or granting them rights to charge the customers (on toll roads concessions). These private companies have infrastructure to design. airports and toll roads. Repair and Overhauling).
Robin Byde* Global Sector Head HSBC Bank Plc +44 20 7991 6816 robin. retail and real estate activities. which often have different economic characteristics. point-to-point. they operate a young and smaller fleet. and earnings correlate with industrial production and consumer demand. These infrastructures require huge investments with a long gestation period. If the regulator permits.5x. These sub-sectors are airlines. In addition. mail (50g letters and small packages). Revenues in this sector are less cyclical while margins tend to improve with the maturity of assets. Supply chain outsourcing is a long-term contracting business and tends to be neutral to the cycle. earnings drivers and valuation references. and land passenger transport (in Europe HSBC covers the UK bus and rail sector).
Logistics and shipping
Most of these supply-chain stocks are cyclical. such as palettes) and supply chain outsourcing services (operating clients’ inventory and warehouse networks). whose volumes correlate with GDP with a multiplier acrossthe-cycle of c1. finance. and provide one class of service and sell unbundled services. Airlines generally operate two business models – full-service network carriers. factors such as catchment area. which combine regional feeder and intercontinental networks.

the European Union plans to start charging for carbon emissions from 2012 when each airline in Europe (other regional airlines flying into Europe) will be charged for carbon emissions above a set limit. it will burden their earnings. yields
and earnings after a big dip in 2008-09. with an expanding supply chain. Departure tax (APD) came as extra burden for European airlines as airports in Europe are charging (or planning to charge) a departure tax per passenger. fuel expenses for global airlines increased by USD55bn in 2008 versus 2007 (IATA).
Logistics and shipping
Trend growth in global freight flows: We forecast slower freight flow growth in the near future due to factors such as near sourcing and a high basis of comparison.
Others: includes restructuring of the network/flag carriers and the ongoing threat of other modes of
transport such as high-speed rail. European airlines are bringing the capacity back slowly. Premium traffic recovery has pulled the yields up. M&A. showing significant growth on soft comparables. Also. The rail industry is highly regulated and heavily funded by government subsidy and a revenue support system. traffic growth may be hampered but if it is (or a part of it) absorbed by airlines. Mid-cycle earnings growth: Clearly 2010 is the bounce-back year for earnings. Alliance growth and cross-border JVs. Slowing of off-shoring: We believe that global freight is at a pivotal point. emissions controls and departure taxes: Higher and volatile fuel prices remain a concern
for airlines.5x GDP for the next few years due to the fragility of the global recovery. particularly in Europe.
Capacity overhang: 2008-09 recession led to overcapacity. If this tax is fully passed onto the passengers.6x global GDP. where operators are funded by the public sector for providing contracted services to Transport for London.
Fuel prices. The trade multiplier in 1995-2007 averaged 2. The UK Rail operation is a largely franchised process with operators winning the right to operate a franchise for a period of around seven years. the expansion of Middle East-based carriers (capacity to grow at 14-15% CAGR 201015) is a worry as this capacity will be deployed on all the routes globally. Currently we forecast a fairly healthy 2011-2012 CAGR of 10-11% in operating profits versus c16% 2004-06. Structural cost cuts have also supported the earnings lift. The rapid growth of the past 20 years with the expanding economy and off-shoring has slowed and even reversed. Operators are not responsible for rail infrastructure but instead they pay access fees to Network Rail. In response to this situation most of the
deliveries of new aircraft were postponed and older aircraft from running fleets were parked in deserts to reduce the capacity. impact of withdrawal of stimulus and near sourcing. The sector has a high correlation with UK GDP. Cargo traffic recovered sharply but passenger traffic recovery is slow. but airlines are expecting yield growth to slow down during the winter (September 2010 to March 2011). We forecast this could contract to 1. Now. with a gathering
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. However. Passenger and cargo yields recovered sharply in Q210.
Key themes
Airlines
Global and regional recovery in demand and yields: Airlines have reported a recovery in traffic. with the slow recovery.EMEA Equity Research Multi-sector September 2010
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FirstGroup and Arriva also operate in London. with a focus now on trend growth through the mid-cycle. unemployment rates and consumer spending.

Peak oil and supply chain security are persuading many production managers to choose Mexico and Eastern Europe over China. is slower.
UK Bus and Rail Sector (Land Passenger Transport)
UK public spending cuts likely to affect the UK bus industry: The bus industry is heavily subsidised (c40-45% of revenue from taxpayers). eroding margins.
Airports and toll roads
Recovery in passenger. are just exploring the PPP model to develop their infrastructure and will provide the value accretion to its shareholders as returns are higher than in developed markets. upside to earnings will be limited by the revenue support mechanism. Volumes are recovering and fares outlook is strong with an expected regulated fare increase of 5. Rail franchise opportunities ahead: Rail passenger revenue trends are strengthening after a stuttering performance in 2009. Expansion in developing markets (Asia and Latin America): These high growth markets. The sector has ridden the expansion of public spending but now spending cuts are looming. as we believe. cargo and road traffic: This is catching up after a big dip in air and road traffic in 2008-09. Up to three new franchises were due to be awarded by the next year – a clear positive for the sector – but government consultation on changes to the franchising system delayed the process. subsidy increases due to the expansion of the London bus network. The revenues realised from the resulting tariff structure and capacity increase (and traffic) should exceed the expenditure incurred.
Supply overhang in container and dry bulk shipping: There is over-supply of container and dry bulk
ships. 2012 London Olympics) and better service than its ferry competitors. However. Companies with dense networks (like Italian toll roads) or good hub characteristics (Frankfurt or CDG airport) are in the best position to show good growth. which de-risks rail franchises four years after they have begun. particularly if trend organic growth. maintenance of commercially unviable routes and people over 60 being given right to free offpeak travel. The deal
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. Political will against operators seems to be growing and investigation by the Competition Commission into non-London bus operations is ongoing. Sector consolidation with healthy balance sheets: Gearing is generally low in the sector and
companies either have strong net cash or neutral positions.
Fuel prices: Earnings of logistic companies are inversely correlated with increase in fuel prices. But with the recovery in demand.8% in 2010 based on July RPI of 4. Free cash generation with large capital expenditure programmes: Regulatory requirements (Atlantia) and capacity constraints (Frankfurt airport) require large capital expenditure programmes. European operators are looking for growth abroad. M&A will rise. Regulation and user demand could be a risk if not analysed properly. laid-up ships are coming back into service. Changing competitive landscape: Facing liberalisation in their home markets. new direct destinations from London. and also assuming assets prices remain comparatively subdued. Companies have reduced the supply by laying up some ships and slow streaming (reducing the speed of the ship).8%. Deutsche Bahn (German railway operator) recently acquired Arriva. Many large projects have been completed and we expect capex to remain comparatively subdued in the next two years. We expect subsidies to come under pressure. HSBC economists expect cumulative real declines in spending of c25% over four years. Eurotunnel has more catalysts here (HS1. Since 1997.EMEA Equity Research Multi-sector September 2010
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trend for production and assembly to be located nearer to end markets.

RAB (Regulated Assets Base) is also used for Airports. EV/EBITDAR. privately-owned market and high margins. IRR is used to value the new concession projects. There are also other variables. to value an airline. Many analysts use a blend of two or more methods mentioned above. (4) gross profit/unit. (3) government funding.EMEA Equity Research Multi-sector September 2010
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reinforces the threat posed by major European operators. REP. PE for low-cost carriers (PE does not work for network carriers due to negative earnings in the down cycle. This could lead to major M&A activities. (4) financial muscles. However.
Airports and toll roads
(1) Traffic volumes growth. EV/EBITDA and DCF are commonly used for valuing the companies. EV/EBIT is used to value the construction business. So competition could intensify and margins may take a hit. (5) parcel shipments per day. (2) airfreight tonnes. (3) passenger and cargo load factor. (2) yield growth.
Logistics and shipping
(1) Global freight flows. and (6) average yields.
Logistics and shipping
PE. (4) passenger and cargo yields (measured in revenue per RPK/per passenger and revenue per FTKs. (2) passenger and cargo traffic (measured in revenue passenger kilometres and freight tonne kilometres). (3) capital expenditure programme. so analysts take different approaches. DCF (as DCF cannot be used as the stand-alone valuation method because the industry is highly cyclical and cash flow visibility is very poor.
Airports and toll roads
EV/EBITDA and DCF are commonly used for most of the segments including toll roads and airports. GDP and industrial production.
UK Bus and Rail Sector (Land Passenger Transport)
SOTP is generally used to value the companies. and SOTP (if the necessary information is available). The most commonly used metrics are: P/BV (versus long run average). The UK is attractive because of its large.
UK bus and rail sector (land passenger transport)
(1) Passenger volume growth. and (5) dividend yield. EV/EBITDA and DCF. In addition. which makes it difficult to calculate the long-run average). (2) road and terminal capacity. such as length of concession rights and visibility in tariff/fee increases through negotiations of regulatory/government bodies. different segments are valued using PE.
Valuation: equity characteristics and accounting dilemmas
Airlines
There is no single method for valuing an airline.
Sector drivers
Airlines
(1) Passenger and cargo capacity (measured in available seat kilometres and available cargo tonne kilometres). generally the results of this method are blended with others).
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. and (4) fuel price. but expansion could also come organically through rail franchise wins or smaller acquisition in bus. (3) sea freight TEUs. and (5) fuel costs (6) gearing. especially in bus.

there are a several smaller esoteric businesses that do not fit neatly into a specific sub-sector such as the fast food delivery company Domino’s Pizza and cinema operator Cineworld. rents and utilities. exhibit real structural growth. but in this report are categorised under Transport. or indeed a hotel to an online gaming company? Broadly the connection is that each company depends on some form of ‘discretionary expenditure’. tour operators and airlines benefit from GDP growth. and most likely will over the long term. As an example.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. holidays. such as for locally sourced produced and healthier menus. going on holiday or gambling as essential. there is greater demand for leisure activities such as eating out. the barriers to entry in the cruising industry are high since large sums of capital are required to acquire a new cruise ship. we think it is best to analyse each sub-sector independently. Meanwhile. knowing that each one has its own unique structure and is subject to different macro and micro drivers. In addition. At the same time. Although clearly not exhaustive. when confidence and incomes are high. tenanted or franchise-based
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. where there is a common denominator for all sector constituents. Travel-related companies such as hotels. as disposable incomes increase in both developed and emerging markets. Alternatively. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Discretionary spend
Unlike other sectors. consumers are unlikely to view expenditure on eating out. while increased globalisation means more people travelling and political change can allow freer movement of people.
Sub-sector drivers
Considering the diversity of the sector.
Ben O’Toole* Analyst HSBC Bank Plc +44 20 7991 3448 ben. hotels. changes in taste and preferences. and catering companies. opening a new restaurant is much easier as there are relatively few barriers in the restaurant industry. freehold versus leasehold sites and property values. such as banks or oil and gas. average spending is high in the cruise industry but volumes are low.otoole@hsbcib. leased. For example. managed. Part of the art of investing in the Travel and Leisure sector is to determine which factors influencing demand and supply are cyclical and which are structural. In contrast.
Long-term growth
Despite this cyclicality. sport events and gambling. while average spending per head in restaurants is low but volumes are high. all sub-sectors have in the past. cruise and tour operators. if economies weaken. For example what connects a pub company to a tour operator. in the travel and leisure sector similarities between companies are more subtle. we have highlighted below some of the key themes to be aware of within each sub-sector:  Pubs and restaurants: growth of the eating-out market versus the decline of the drinking-out market. bookmakers and gaming companies. One should note that airlines and bus and rail operators also fall under the travel and leisure umbrella.EMEA Equity Research Multi-sector September 2010
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Sector description
The travel and leisure sector comprises numerous diverse sub-sectors including pubs and restaurants. confidence falls and individuals and firms cut discretionary spending to ensure sufficient income is available to cover more important expenses such as staples. even if it is enjoyable. spending on discretionary items is also likely to be strong. It is the dependence on discretionary spending that makes the sector more cyclical than many others. Moreover.

labour is more often than not one of the highest costs. changes in duty and taxes. asset-light versus owner-operated business models. disintermediation caused by the internet. although this is being offset by capacity increases in the number of food-led pubs and other restaurants. In the more mature industries. fuel costs and changes to excise and duty rates. although businesses tend to have long-term contracts with suppliers in order to reduce volatility. the current lack of available finance to build new hotels means supply is barely increasing. penetration levels vary across industry sectors and regions.
Input costs
Yet again input costs differ between sub-sectors. geo-political risk and climate change. such as growth in football betting and the decline in horse racing betting. with flights and rooms being upgraded to premium categories in the good times. loyalty schemes.
Capacity and capex
Capacity varies considerably depending on the sub-sector.  Caterers: size of overall market and potential growth of outsourcing. Corporate spending on airlines and hotels usually fluctuates with the economy. types of contract.EMEA Equity Research Multi-sector September 2010
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operating models. demand has recovered strongly. asset values. opportunities in facilities management. but travel restrictions quickly being enforced in tougher economies.
Sector drivers
Consumer and business confidence
Quite simply. growth of low-cost carriers. Meanwhile. social acceptance and awareness of gambling. input cost inflation.  Bookmakers and gambling: high growth in online versus subdued growth in land-based gambling. growth of independent travel. changes in tastes and preference. When online gaming was outlawed in the US. In comparison the long-term declines in the UK’s drinking-out market mean the capacity of wet-led pubs is in decline. cyclical or defensive.  Cruise and tour operators: changes in aircraft and ship capacity. changes to global regulation. changes in booking patterns. taxes and duties. pubs and restaurants and fuel costs for cruise and tour operators and airlines. increasing confidence means greater discretionary spend. capex tends to trend in line with depreciation. exchange rates. which has helped hoteliers increase prices over the last 12 months. input costs (food and labour). changes in regulation. and when smoking was banned in all work
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. a fragmented industry with consolidation potential.
Changes in regulation and taxation
Changes in regulation often create big operation risks. competition from supermarkets and the off-trade. These costs ultimately depend on commodity markets.  Hotels: penetration of branded hotels versus non-branded hotels. Other key costs are food and beverage costs for hoteliers. However. unless operators are actively looking to roll out more units. but it is also worth considering business confidence. recovering demand and limited new hotel capacity. changes in corporate travel budgets. We have outlined that relationship for consumers above. Within the hotel industry. particularly in developed markets. low growth in developed markets versus growth in emerging markets. such as pubs and land-based bookmakers. operators lost more than half of their global market overnight.

a DCF valuation is often favoured. due to the change in customer mix. where the operators do not own the asset. if sales fall. which a price/NAV would account for. due to the seasonal nature of their businesses. but suppliers are often paid 90 days later.EMEA Equity Research Multi-sector September 2010
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places in the UK in 2007 (which includes public places such as bars and restaurants). and capitalising the annual lease cost at 8x is often used. Since expenditure in the sector is discretionary. where the operators own the assets. with food sales. One issue to be aware of is operating leases. we think the most commonly used are relative multiple analysis and discounted cash flows with returns-based measures and asset values providing support. usually at the start of the calendar year. and asset-light. The asset-light model tends to attract a higher multiple as returns on capital are higher. gambling and air travel are obvious examples.
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.
Accounting issues
Most operators have fairly predictable cash flows since customers pay for their goods and services when they receive them. Alternatively investors can focus on the fixed cover charge. it is often an easy target for governments to tax. Take for example the pub sub-sector. and this in most cases means accounting standards are fairly straightforward. However. and there is a working cash outflow. then working capital tends to be positive. However. but control the brand and marketing using management contracts and franchise agreements. the potential full liabilities are not capitalised on the balance sheet. a calculation is made to determine adjusted net debt/EBITDAR. they can see a large swing in working capital from the time cash comes in over the summer months from customers paying the balance of their holidays. which can often support more debt. Therefore the conversion ratio of operating profit into free cash flows tend to be high. Assuming the top line is growing.
Valuation: equity characteristics and accounting dilemmas
Valuation
Understandably there is not one valuation methodology that is appropriate to the whole sector. In our view. the actual level of gearing can be understated. since cash is paid when goods and services are acquired. a DCF fails to consider the asset backing inherent in the freehold pub companies. wet-led pub operators quickly had to substitute declining alcohol sales. This is particularly important for tour operators as. Another area to focus on is working capital. but the capital-intensive model clearly has support from the asset values. the best way to approach valuation is to use a range of methods. which takes into consideration both interest costs and rent. to the low point. Investors need to be aware that as these liabilities are often spread over a long period of time. Since the industry is mature and variables such as revenues. when they pay hoteliers for their allocation of rooms for the prior year. costs and capex and therefore cash flows are relatively predictable. then less cash comes in but suppliers still need to be paid. which can be used for property assets such as real estate and aircrafts. Likewise in the hotel industry there are two models – capital-intensive. duties on alcohol. To compensate for this. Since these assets are simply leased. However. In fact there is not one relevant methodology within most sub-sectors.

For electricity and gas. usually via listed subsidiaries.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc. energy policy and regulation in Europe are being centred on three overarching objectives: energy security. However. infrastructure activities (transmission and distribution networks and pipes) are subject to regulated returns. However.EMEA Equity Research Multi-sector September 2010
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Sector description
Traditionally seen as a defensive sector but earnings volatility increasing
The European utilities sector encompasses companies operating across the value chain in electricity. environmental legislation (Kyoto targets). However. there have been calls from within the industry
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.
Climate change energy policy – subsidy pressure
The ‘20-20-20’ EU goal aims for a 20% reduction in primary energy consumption and carbon emissions. environmental protection and affordability. Owing to the fall in load factors of conventional thermal plant. In several of the EU’s major markets (France and Germany) the former monopolies still control the transmission and distribution networks. These companies hope to take advantage of renewable subsidies to offset the lower profitability of their conventional plant by involving themselves in renewable activities. and for 20% of energy needs in the EU to be met by renewables by 2020. water and environment services. Regulation in individual member countries is being shaped by the broader EU objectives of an ‘internal energy market’ and the ‘20-20-20’ initiative for 2020 aimed at energy efficiency. unregulated activities have become less defensive as political pressure (the threat of re-regulation). for the most part) caused by the construction of renewable plant – particularly wind.mitchell@hsbcib. but lower in retail supply (single digits) owing to competitive pressures. Environmental and waste services are competitive activities. gas. The impact of climate-changerelated policy will continue to affect the utilities sector. and to reinforce the existing grid to withstand huge fluctuations in renewable output. water supply activities in England and Wales are subject to regulated returns in contrast but are unregulated in France. oil and gas exploration and production. lack of interconnection among networks and barriers to cross-border M&A activity have put a brake on this aspiration. These activities are lightly regulated in Europe. the sector is traditionally seen as a defensive sector or yield play. and is not registered/ qualified pursuant to FINRA regulations
Key themes
Power
EU energy policy and regulation – competitive pressure
Given the challenges of rising energy demand. The non-regulated companies will suffer as a result of the reduced load factor from existing plants and the limited load factor from new flexible plants (CCGT. competition is still weak and there are high barriers to entry owing to high capital costs. Although network activities have been legally unbundled from generation and supply activities in most countries.
Verity Mitchell* Analyst HSBC Bank Plc +44 20 7991 6840 verity. upstream activities include: power generation. competition and volatility in commodity prices have contributed to eroding margins. Operating profit margins are higher in more asset-intensive and regulated activities. while downstream activities are related to retail sales and services. As regulated networks are relatively immune to economic cycles. The regulated companies will potentially benefit from the need to build new grid to connect renewable energy installations. finite fossil fuel resources and the need to protect the environment. Members are targeting the establishment of an EU-wide internal energy market as a means of promoting competition and giving consumers a choice of suppliers.

Iberdrola. In the wake of the German nuclear tax.
Growth areas: Emerging markets and renewables
Faced with low growth in mature western European markets. Italy. In late March 2009 Finland said it intended to levy EUR30m-330m starting from 2011. (ii) Russia: Fortum (TGK-1. International Power.
Water
Investment in growing asset bases
Water companies continue to invest in the water network.ON for example) for capacity payments to be paid to generators for running conventional flexible plant as a means of guaranteeing security of supply when renewable generation output fails (wind.ON (OGK-4). TGK-10). and (iii) Middle East and Asia: GDF Suez. However. Central and Eastern European (CEE) countries will have to do likewise by 2020. hydro). the prospect of regulatory risk has now moved on to Spain. Under the current EU-ETS. It has also reduced spreads (the profit margins achieved by generators).
Political risk increasing
Political and regulatory risk increased with the economic downturn. Also. rehabilitating ageing pipes and enhancing waste water treatment. new build will be increasingly required in the second half of the next decade irrespective of the degree of demand recovery. Gas Natural. Major companies with a sizeable presence in renewables and exposure to high-growth markets include Iberdrola.7/MWh of nuclear output (revised in 2008). The EU cap-and-trade system – the European Union Emissions Trading Scheme (EU-ETS) – is a mechanism for encouraging companies to reduce carbon emissions by requiring them to purchase carbon certificates to cover amounts that exceed their free allocations. utilities have expanded their investment in renewables and their presence in emerging markets (CEE. There will also be a need to invest in network reinforcements. EDP and Enel (through Endesa). as close to 60% of its conventional plants are in the second half of their lifecycle. These supply-side constraints call for significant investments. Belgium imposed a levy of EUR250m on its nuclear industry in 2008 and 2009.
Energy security and an ageing European fleet – medium-term profit outlook improving
The economic crisis led to an increase in the capacity reserve margin (unallocated power available to the grid) and has reduced the need for new investments. Whereas Belgium and Sweden already tax nuclear power. We believe these pressures could lead to a recovery in spreads and profitability for the sector. By 2013 most Western European countries will have to purchase 100% of their requirements. and Sweden already levies EUR6. a significant number of non-compatible plants are expected to close in 2015.EMEA Equity Research Multi-sector September 2010
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(E. and Enel (OGK-5). E. The UK power companies contribute to a poverty package for consumers but. EDP and Enel. Russia. generators receive a varying amount of carbon emission certificates free of charge and will do so until 2012. Germany intends to raise EUR2. to comply with EU directives – most notably those covered by the EU Water Framework
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. Belgium and Finland. under the EU Large Combustion Plant directive (LCPD).3bn annually from the nuclear power generators as part of its 201114 austerity plan. Latin America and the Middle East) in search of growth. Markets include: (i) Latin America: GDF Suez. and in clean technologies. as EU governments again recognised the possibility of using utilities’ profits and/or driving down regulated utility returns to reduce customers’ bills. Europe has a plant ageing problem. given the need for investment – especially in new nuclear – we view heavy taxes on generation as less likely in the UK. Finland now intends to do so as well.

 Commodity prices and power activities: Higher economic growth and consequently higher fuel prices (oil.
Unregulated stocks
The profitability drivers of unregulated activities are explained below:  Demand growth: Overall. earnings tend to be highly geared to commodity prices. nuclear and lignite). while stable regulated returns provide visibility on dividends. financial efficiencies. and (iii) operational. Australia. The UK water companies are allowed to increase their prices each year using the ‘RPI – x + K’ formula. For equity investors. gas. Other factors affecting energy demand are demographic changes and advances in energy efficiency methods. as variable costs for such technologies are very low.
Sector drivers
For utilities.
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Directive (2013). (ii) the level of allowed returns/WACC. because of the regulated nature and high visibility of returns. where x denotes the efficiency savings factor and K is the factor used to raise prices to cover the financing of new capital expenditure and other expense items related to the improvement of its assets. Thus. utilities typically sell power forward up to three years in advance to mitigate the impact of commodity price volatility. The profitability of power generators also depends on the nature of their assets. For power generators with baseload assets (hydro. Reduced demand caused by the economic recession has been a negative influence on the waste management activities of the water companies. For mid-merit (coal and gas) plant operators. Companies may extract a return higher than the allowed/approved return through operational and/or financial efficiencies.
Regulated stocks
Regulated network activities are remunerated through an approved return (WACC) on a RAB. short-term volatility is a key profit driver. the RAB (regulated asset base) or RCV (regulatory capital value) is the asset value (calculated by the regulator in every five-year period) on which companies earn a return based on an approved WACC that is revised in every regulatory period. Moreover. the key profit driver is the spread between power prices and associated fuel and carbon costs. especially in areas of acute water shortage – Middle East. for peaking (gas. profits for regulated activities are a function of: (i) investment/RAB growth. the scarcity of project finance and the austerity measures by many governments and municipalities led to fewer water treatment and desalination project awards over 200910. industrial demand being more cyclical and residential demand being stable. and their key profit metric is the achieved power price. coal) result in higher power prices – a trend that benefits upstream power generation companies but hurts downstream suppliers. China and some parts of the US. In addition to engaging in downstream retail activities that act as a natural hedge to upstream generation. energy demand is directly linked to the pace of economic growth.
Global scarcity
For the French water companies. in the range of 55-65%. For UK water companies. oil and pumped storage) plant operators. We believe contracts will be awarded and growth will resume. Demand growth also affects environmental services. Finally. the RCV provides a spot reference point as to whether the stock is trading at a premium or a discount. the proportion of debt to RCV tends to be high. earnings drivers differ depending on whether the operations are regulated or unregulated.

so movements in spot gas prices versus long-term contracted gas price determine the profitability of gas suppliers. is linked to the level of economic activity and the structural demand-supply balance in a market. On the demand side. (iv) asset valuation: application of a premium or discount to the RAB depending on the quality of assets. Most utilities report a recurring operating metric that excludes one-off items. for example. Dividend.  Demand-supply mismatch and level of integration: Power prices and pressure on spreads tend to be lower where reserve margins are comfortable (ie supply exceeds peak demand). and captures long-term growth. the focus is on arriving at
a recurring or EBITDA or EPS. with baseload technologies (renewables. in turn. Albeit for the time being the level of interconnection in Europe remains relatively low. (iii) residual income method: the technique focuses on value creation through a company’s ability to earn returns above the level allowed by the regulator. they are low in the
downstream or retail supply of power or gas owing to intense competition.
Valuation: equity characteristics and accounting dilemmas
Valuation parameters
Regulated or midstream activities: For regulated stocks whose infrastructure/networks assets produce
relatively stable returns. Downstream gas suppliers in Europe mostly secure gas on long-term contracts (indexed to oil prices). such stocks tend to trade at higher market multiples during an upturn in commodities. nuclear and lignite) deserving a higher valuation than the mid-merit to peaking technologies (coal. which is among the sector’s principal attractions. hydro.
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.  Weather: The weather affects the sector on both the demand and supply sides. whilst on the supply side. gas. or upstream oil and gas. and vice versa. the preferred valuation techniques are: (i) DDM: higher dividend visibility given stable regulated earnings and a defined dividend payout range. Consequently. with more value being assigned to customers with combined power and gas supply.
Upstream activities: Unlike regulated stocks. the level of interconnection between countries can influence the level of prices through the import/export of energy.
Key accounting metrics
Earnings metrics: As the favourite market multiplies are EV/EBITDA and PE. Retail activities are typically valued by ascribing a DCF/customer value to the number of customers.
Downstream activities: Although profit margins are high in upstream activities. utilities whose business model is dominated by upstream
power generation. oil-fired plant and pumped storage plants). Also. wind conditions and water/hydro reservoir levels affect the level of electricity production from renewable energy sources. Power generation assets are typically valued by the DCF/MW of a particular technology. coal and carbon). which. Given investors’ preference for consistent dividends. (ii) DCF: the source of value is the company’s ability to generate free cash flows and long-term growth. gas. most utilities try to maintain a stable growth rate in dividends and offer visibility on payout (the typical range for large utilities is 50-60%).EMEA Equity Research Multi-sector September 2010
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 Commodity prices and gas activities: The profitability of upstream E&P operations is a direct function of the trend in oil and gas prices. have volatile earnings that are geared to trends in commodity prices (oil. a cold winter can increase energy demand. is often linked to recurring EPS.

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Notes
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and is not registered/qualified pursuant to FINRA regulations
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Basic Accounting Guide
*Employed by a non-US affiliate of HSBC Securities (USA) Inc.

Scoring range 1–5 (high score is good) New entrants
Barriers to entry will be high if economies of scale are important. are they new and innovativ e Quality process and procedures Specialist marketing expertise
Scoring range 1–5 (high score is good) Weaknesses
      Undifferentiated products and services. fixed costs are high. Downstream integration: the industry can be disintermediated.
Substitute products
Alternative means of fulfilling customer needs through alt ernative industries will put pressure on demand and margin s. growth is slowing. If switching costs are hig h. Substitute producers provide a price ceiling. substitution of need (precision casting makes cutting tools redundant).
Power of customers
Buyer power will be high if buyers are concentrated with a small number of operators where there are alternative types of supply. existin g players are likely to squeeze out new entrants. suppliers can put pressure on the in dustry.
COMPANY Strengths
      Patents Strong band and/or reputation Locatio n of the business T he products. strategic alliances Loosening of regulations Removal of international trade barriers Moving into a new market. switching costs are low. generic substitution (furnit ure manufacturers vs holiday companies). Similarly the bottom number scores the balance of opportunities and risks. there is a liquid market for corporate control and exit barriers are hig h.
Rivalry
High rivalry will result from the extent to which players are in balance. avoidance (tobacco). where switchin g is easy and low cost and the threat of upstream integratio n is high. Product for product (email for fax). capacity increases require major incremental steps. there is a steep ? experience’ curve. legislation or government action prevents entry. innovative substitute product or service Rivals have a superior access to channels of supply and dis trib ution Increased trade barrier Taxation and/or new regula tions on a product or service
Source: HSBC Note: The upper score represents an assessment of the balance of strengths and weaknesses. be through new products or new market place Market lead by a in effective competitor
Threats
      New Competitor Price war Competitors has a new.
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. Brazil Mergers. (ie low value added). customers are glo bal. A sin gle strategic supplier can put pressure on industry margins. where material costs are a high component of price. access to distribution channels is restricted.EMEA Equity Research Multi-sector September 2010
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Five Forces and SWOT
INDUSTRY Power of suppliers
A concentration of suppliers will mean less chance to negotiate better pricin g. in relation to the market Poor qualit y goods or services Damaged reputation Competitors have superio r access to distribution channels Locatio n of the business Lack of marketing expertise
Opportunities
      Developin g market eg Internet. branding or differentia tion is high.

Also included is a brief introduction to balance line items. The valuation measures and methods described below apply only to listed companies. it helps to indicate the relationship between the different competitive forces within the industry. because it takes into account the value of debt for a company (and also adjusts for minorities and associates) to make it suited for ratios above the interest P&L line such as EV/sales. EV/EBITDA and EV/EBIT. It is felt by many to have more uses than market capitalisation. this makes Core EV more subjective but can be used for ratios such as Core EV/core business sales. Five Forces can be used by a business manager trying to develop an edge over a rival firm or by analysts trying to evaluate a business idea. core and operating. while the opportunities and threats (OT) are the many external factors that a firm must account for. Porter’s Five Forces has a scoring system in which positive. The higher the score the more sound the industry. Strengths and weakness (SW) apply to any internal factors within the firm. or business is.
Valuation
The following sections give a brief introduction to the main accounting issues and valuations techniques. There are three types of enterprise value: total. such as pension deficits) + minority interests – associates (both fair value). This accounting guide can be used to help gain a better understanding of company’s financial statements.
Enterprise value
Total Enterprise Value
The value of all business actives
Operating Enterprise Value Total EV less non-operating assets at market value
Core Enterprise Value Total EV less non-core assets.
Source: HSBC
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. then how it is valued. It is structured by addressing: what is valued. Calculate by: market capitalisation (all share classes) + net debt (and other liabilities. then the inputs of the valuation. Porter’s Five Forces is an analytical approach which assesses industries or a company by five strategic forces. negative or neutral results are combined to give a final score for each force.EMEA Equity Research Multi-sector September 2010
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The figure above combines a diagram of Five Forces model for analysing an industry with an outline of a SWOT analysis for evaluating a company. SWOT analysis is routinely used to help the strategic planning of a firm into the business world. their definitions and ratio analysis.
Valuing what?
Enterprise Value (EV)
An enterprise is a company and therefore the enterprise value is a measure of the whole company’s value.

For example. A company with more cash than debt would be said to have Net Cash. Consolidated accounts show 100% of sales. this being the minority interest. the company’s liabilities (and contributions) are variable. where Company B is a GBP100million company. if Company A owns 80% of Company B.
Net Debt
This is the total amount of debt and liabilities a company has after subtracting the value of its cash and cash equivalents. EBITDA. DCF valuation. at fair value (rather than the book value used in the balance sheet). it is useful as part of EV and for ratios such as PE (price/earnings = market cap/net income) or DY (dividend yield = dividends/market cap). The pension in retirement depends on the cumulative contributions to the fund. The benefits are fixed but. returns from its investments and annuity rates at retirement. as the actuarial assessment of the liability depends on changing factors (such as life expectancy and discount rates).  As an adjustment in EV. here the employers’ contributions are fixed but the benefits are variable.
Pension Obligations
This is a projected sum of total benefits which an employer has agreed to pay to retirees and current employees entitled to benefits. excluding treasury shares owned by itself) by the current market price of one share. Company A will have a GBP20 million liability. The company has an obligation to pay out the determined benefit and if there is a shortfall in the fund. etc. eg ‘owning a minority interest’  Or non-current liability on a balance sheet representing the portions of its subsidiaries owned by minority shareholders. There are two main types of pension scheme:  Defined Benefit.  Defined Contribution. EBIT (in the P&L). For example if the fair value was GBP30m then this would be added to EV and deducted as part of the DCF. Calculate by: multiplying companies’ shares outstanding (ie.EMEA Equity Research Multi-sector September 2010
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Market Capitalisation (Market Cap)
The value of all the shares of a corporation. 100% of the assets and liabilities (in the balance sheet) and 100% of the cash flows of a subsidiary but also deduct the minorities’ shares of profits in a separate minorities P&L line. their share of net assets in a minorities balance sheet line and any dividends paid to them in the cash flow.
Minority Interest – three main definitions:
 Where an investor or company owns less than 50% of another company’s voting shares.
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. where payment is linked to employees’ salary level and years of service. to represent the 20% of Company B that it does not own. must draw on the company’s profits to subsidize the discrepancy. on its balance sheets.

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Common terms used to discuss pensions
Accumulated Benefit Obligation (ABO) Discount Rate Prior Service Costs Projected benefit Obligations (PBO) Service Cost Vested Benefit Obligations (VBO)
Source: HSBC
An estimate of liability if the pension plan assumes immediate discontinuation. though too much cost cutting or underinvestment can be risks. as the employee continues to work.
For a project lasting n years calculate by: For a business lasting beyond the n years for which you have estimated cash flow. Calculate by: EBITDA – capex – working capital change – net interest – tax
Free Cash Flows to the Firm (FCFF)
The cash flow after everything except interest (net of tax) and dividends. Retrospective benefit costs for services prior to pension plan commencement or after plan amendments. used in performance measures (eg FCF Yield = FCF/market cap). This assumes the pension plan is ongoing. and this is ‘Vested’. It is the sum of the value of each period’s FCFF.
Free Cash Flow (FCF)
The cash flow after everything except dividends. Generally the higher the FCF the better. so attributable to shareholders. used in DCF calculations (see below). add a ‘terminal value’. if thought to be a
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. discounted back to the present day. The rate used to establish the present value of future cash flows. There are several different measures. The VBO represents the actuarial present value of vested benefits. The value at year n+1. The present value of benefits earned during the current period Most plans require a certain number of years service before benefits can be collected. it does not take into account any future salary increases. being the value at year n discounted to the present day. used for different purposes. and therefore it projects future salary increases. ie adjusted for the time value of money. plus a cash flow statement in the reports and accounts. Calculate by: EBITDA – capex – working capital change – tax
Discounted Cash Flow (DCF)
The present value of an investment.
Valuing how?
Cash Flow
This indicates the amount of cash generated and used by a company over a given period. at least in the short term.

It is usually calculated on an enterprise basis: with EBIT. say. A low PEG company may reflect high risk. would have a value in year n of CFn (1+g)/(r-g) and a present value of CFn(1+g)/(r-g)/(1+r)n
Market Assessed Cost of Capital (MACC)
MACC turns conventional valuation methodology around. depreciation and amortisation) is also above the interest. As sales are above the interest. with the company keeping profits steady (if fully distributed as dividends). capital employed including financed by debt and weighted average cost of capital (WACC – see below). while the smaller the PE is an indication that the companies are low-growth or mature industries. Generally companies with high PE (over 20) are faster growing. so comparing to EV is consistent and popular. Residual Income
This is a measure of the company’s profits.
PEG ratios Price to Book Ratio (P/B ratio) EV/Sales. Calculate by: Net Sales – Operating Expenses = Operating Profit (EBIT) EBIT – taxes = Net Operating Profit after Tax (NOPLAT) NOPLAT – Capital Costs = Economic Value Added (EVA)
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. tax.Liabilities (equal to price / book value per share) EV (see page 1 to calculate) Annual Sales EV (see page 1 to calculate) Annual EBITDA
This ratio is used to determine a stock’s value taking into account earnings growth. associates and minorities lines.EMEA Equity Research Multi-sector September 2010
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perpetuity growing at rate g per annum. instead of comparing returns on capital and cost of capital to arrive at an estimate of fair value. or for use against peers. This MACC value can be used to compare against historical observations for the same stock.
EV/EBITDA
Economic Value Added (EVA).
Multiples
Multiple Calculation Definition/Interpretation
PE ratio
Price of a stock Earnings per share
Helps to give investors an overview of how much they are paying for a stock. especially if growth is very high. it can be compared throughout the same industry sector. It can be based on net assets or after deducting intangibles. price/sales. it is more consistent and popular to compare EV (including net debt and adjusted for minorities and associates) to sales than. associates and minorities lines in the P&L. it compares market return on capital with market value to arrive at an estimate for market assessed cost of capital (MACC). This ratio compares stock market value to book value. taxes based on EBIT. after deducting capital costs (being the capital employed x cost of capital).
Price/Earnings Ratio Annual EPS Growth Market capitalisation Total assets .Intangible assets . the ratio states how many years it would take for the investors to recoup their investment. EBITDA (earnings before interest.

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Components and inputs of valuation
DCF Inputs
Weighted Average Cost of Capital (WACC)
This calculates the firm’s cost of capital. Calculate by: Long term debt +Stock + retained earnings
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. It is useful to estimate the cost of equity for a stock as an investor can. It is used with pre-interest cash flows (eg DCF) or profits (eg Economic Profit). It is usually higher than the risk-free rate (eg 10-year government bond yields) due to the spread over such bonds that corporate bond holders tend to demand. representing the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. in principle. diversify away uncorrelated risks but not correlated sensitivity to the market.
MACC Inputs
Invested Capital (IC)
This is capital that the company can invest within itself or has already invested internally.
Cost of Equity
This is in theory the return a stockholder requires for holding part of a company. It is a measure for the general stock market rather than individual stocks. Calculate by: WACC = E *Re (E+D) + D *Rd * (1-Tc) (E+D) Re= cost of equity Rd = cost of debt E = market value of the firm’s equity D = market value of the firm’s debt Tc = Corporate tax rate
Cost of Debt
This is the effective rate that a corporation pays on its current debt. with each category of capital proportionally weighted.
Equity Risk Premium
This is the premium investors would expect for investing in equities due to the higher risk.or posttax. it can be measured either pre. Calculate by: Risk-free rate + equity beta x equity risk premium
Equity Beta
The correlation between a share and the general stock market.

Sales
Total amount of goods sold over a given period. and often is. usually reported net of any sales taxes (eg value added tax). which may be headline or adjusted (for example to exclude the impact of nonrecurring items). Shares are normally in issue (excluding treasury shares owned by the company). Each asset. Calculate by: Where. SG&A (selling. The fair value of an asset may be higher than its book value.
Operating Expenses (OPEX)
Any expenses which are brought about by the operations of the company. stock or. company property. taking into account depreciation that may have happened every year after the asset was brought. returns. and damaged or missing goods or sales taxes (eg value added tax). the cost of goods sold.
Net-Operating-Profit-Less-Adjusted-Taxes (NOPLAT)
This is operating profit (net sales less opex) minus the tax that would be paid if there were no other factors (such as tax-deductible interest). it can either be paid quarterly.g.
EVA Inputs
Net Sales
This is the sales figure with deductions for any discounts. It can be paid in money. and  GCI: Gross fixed assets plus Gross intangible assets plus net working capital plus cash Gross Cash Flow Average Gross Cash invested (GCI)
Multiple Inputs
Earnings per share
Net profit per share. However. from the smallest piece of equipment to the whole business.
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. has a book value. The occurrence of the dividend payment depends on the company. Calculate by:
Book Value
Net profit for the year Number of shares
The value at which an asset is carried on the balance sheet. half yearly or once a year and may be ordinary (usually expected to recur) or special (often non-recurring).
Dividend
This is the distribution of earnings to the shareholders. if the fair value is lower then the book value ought to be written down to fair value. It does not include non-operating costs (such as interest or tax). general and administrative expenses).  Gross Cash flow is operating cash flow plus post-tax gross interest expense. e.EMEA Equity Research Multi-sector September 2010
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Cash Return on Capital Invested (CROIC)
This evaluates a company’s cash return to its equity. very rarely. it measures the cash profits of a company and compares this to the proportion of the funding required to generate it.

A higher ratio is preferable. it is a rate of profitability. This ratio shows how many times a company’s inventory is sold and then replaced over a year. This implies the number of times a debtor is turned over every year.
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. Its weakness is that it depends not only on operations but interest. The amount of sales generated by each dollar (or whatever unit sales are measured in) worth of assets. Measures profitability from an operating point of view. A high ratio is good for low working capital requirement. by indicating the ratio of debt to equity. It may be useful when estimating a floor value of a stock (if the dividend is sustainable). Some funds target high-yielding stocks (called ‘Yield Funds’). for both shareholders and bond holders. Also measures the ability of a company to pay its short-term debt but with its most liquid assets. This indicates the debt servicing capacity of the company. Investors often prefer a high ratio but a low ratio retains more earnings for use in the business. Used when comparing companies in similar industries. It does not depend on leverage so is more comparable across a sector. Indicates how much a company pays out in dividends relative to its share price.
Cost of Goods Sold (COGS)
The cost of buying or making the goods sold in the period
Gross Margin
Gross Profit (sales less COGS) as a percentage of sales. etc.
Quick ratio Debt/equity ratio Net Profit Margin ratio
Current assets – Inventories Current Liabilities Financial liabilities Shareholder’s Fund Profit after tax Sales EBIT Interest Net Income Shareholders Equity * 100 NOPLAT Total Capital Sales Assets Sales Inventory Sales Average Debtors Credit purchase Average Creditors
* 100
Interest coverage ratio Return on equity (ROE) Return on invested capital (ROIC) Asset turnover ratio Inventory turnover ratio Debtors turnover ratio Creditors turnover ratio
Dividend payout ratio
Yearly dividend per share Earnings per share Annual Dividends per Share Price per Share
Dividend yield
Income statement line items
Sales or Revenues
The total amount of money in a given period that a company obtains after deductions for discounts and returned merchandise and usually after deducting any sales taxes (eg value added tax). the greater the buffer. the safer the debt holders. Measures a corporation’s profitability from a shareholder’s point of view.EMEA Equity Research Multi-sector September 2010
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Key accounting ratios
Ratio Calculation Definition/Interpretation
Current ratio
Current assets Current liabilities
This indicates the ability of a company to pay its debts in the short term. It depends on operating success and leverage. This indicates the credit period that firms benefit from before they pay off their creditors. This measures the company’s financial leverage. This is the percentage of earnings paid to shareholders in dividends. A high ratio indicates that the creditors are being paid promptly while a low ratio is good for working capital. A higher ratio is preferred.

etc. etc. Calculate by: Revenue – Operating Expenses
Interest
Financial income (on cash. it is after D&A but before interest and other financial charges and taxes.).
Tax
Taxes on company profit. tax and minority charges (the share of any profits attributable to minority shareholders of subsidiaries of the company). Tax. If Company A buys a piece of equipment with a patent for GBP25m and the patent lasts for 10 years.
Amortisation
This is a reduction in the cost of an intangible asset through changes in income. General & Administrative Expenses (SG&A)
This is operating costs other than COGS. in opex). property cost. plant and equipment. ie after interest. is for tangible assets such as land.
Net profit. Some companies also include their share of profits from associates. GBP2. by contrast. dividends from investments and various other factors (eg f/x gains and losses) in a Financial Items line along with interest. If an asset is depreciated over its useful life. (Depreciation. between gross profit and EBITDA in the P&L. It is one of the most used ways of comparing the performances of differing companies. Depreciation and Amortisation (EBITDA)
It can be used for comparing profitability and efficiency ratios for a firm. etc.
Depreciation
The reduction in value of an asset through time.EMEA Equity Research Multi-sector September 2010
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Selling. etc.
Pre-tax Profit (PTP)
Profit after interest but before tax has been taken away from it.)
Operating profit or EBIT
Earnings Before Interest and Taxes.5m each year would be recorded as amortisation. it may well need replacing when fully depreciated at end-of-life. building. It is non-cash (the cash already having been paid to acquire the asset) but a part of the P&L and annual reduction in balance sheet asset value. net income or earnings
Profit after everything (except dividends which are a distribution of earnings.
Earnings Before Interest.
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. Note: The above items should appear in most P&L accounts (financial companies often being a notable exception) while the below items are rarer. EBITDA less depreciation and amortisation is EBIT. after dividends would be called retained profits). as opposed to sales taxes (usually deducted directly from sales) or operating taxes (usually added to staff cost.) less expense (on bonds. bank debt. use.

goodwill. or assets that are expected to be sold.
Non-Current Assets
Assets not easily convertible to cash.
Current Assets
Assets expected to be turned into cash within the coming year.
Clean profit
Restructuring and other non-recurring costs (or income) are often separately identified by companies to help understand and predict future profits and often adjusted for in ‘clean’ profit measures. such as corporate intellectual property rights.
Balance sheet line items
Assets
Anything owned by a business that has commercial value.
Intangible Assets
An asset that is not physical in nature. banks unlikely to collect all the money lent provide for the proportion they expect not to collect. eg clean EBIT. brand recognition.
Receivables
All accounts receivable and debt owed to a company. disposed of or abandoned.
Investment assets
An asset not used within the company’s operations. or not expected to become cash within the next year.
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. whether they are due in the short or long term. For investors it indicates what the business could rationally be expected to replicate in future. Provisions are often included within COGS or SG&A. For example. Also known as long-life assets. etc. This is reported separately in the accounts to continuing operations.
Fixed Assets
Assets that a company uses over a long period of time.EMEA Equity Research Multi-sector September 2010
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Provision
Costs are provided for if they are expected but have not yet been paid. they are not expected to be sold on.
Deferred tax assets
The present value of tax credits (eg from past losses) are expected to reduce future tax payments that would otherwise be incurred. damages for a law suit expected to be lost.
Discontinued Operations
These are any segments of a business that have been sold.
Continuing Operations
These are the segments within a business that they expect to continue functioning for the foreseeable future.

accumulated during their service. generally high liquidity and relatively safe.
Provisions for liabilities and charges
Liability value is not known accurately and therefore an amount is set aside to cover it. for example the estimated cost of restructuring or losing a legal case. this must either have been provided to the company through issuing shares or have built up through retained earnings.EMEA Equity Research Multi-sector September 2010
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Inventories
The value of the firm’s raw materials. even if there is a rise in share price this is not taken into account. They include short-term debt. unpaid wages.
Liabilities
Money. net assets = total assets – total liabilities = share capital + retained earnings = shareholders’ equity.
Trade and other payables
Liabilities to suppliers. or by share capital + retained earnings
Share capital
The original value of the shares issued by a company. work in process. therefore. for example a treasury bill. supplies used in operations and finished goods. Shares may be issued at the creation of the company or later and may be at nominal value or with a share premium on top.
Financial liabilities: debt and financial derivatives
Bonds and borrowings from banks and other lenders that must be repaid (with interest).
Retirement benefit obligations
The present value (usually net of tax) of the expected liabilities for payments to former and current staff for pensions. healthcare. services and goods that are owed by a company.
Non-current liabilities
Liabilities not expected to be paid with a year. tax due. etc. etc. net assets
Total assets less total liabilities (excluding shareholders’ equity itself).
Current liabilities
Liabilities expected to be paid throughout the coming year. Therefore. By definition. Calculate by: Total assets less total liabilities.
Shareholders’ equity.
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. payable accounts.
Cash & cash equivalents (CCE)
Assets already in cash or that can be converted into cash rapidly.

Revenue and expenses
These include cash receipts from sale of goods and services and cash payments to suppliers for goods and services. building inventory.
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Proceeds from sale of financial assets
The money gained by selling the financial asset.
Expenditure on intangible assets
Buying or selling of intangible assets which contribute to the company. advertising.
Net cash flow from investing activities
This reports the change in a company’s cash position resulting from losses or gains from investments that have been made in financial markets or operating subsidiaries. Calculate by: Closing retained earnings = opening retained earnings plus earnings in the period less dividends declared in the period.EMEA Equity Research Multi-sector September 2010
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Retained earnings
Cumulative total earnings minus that which has been distributed to the shareholders as dividends. dividends received on equity securities. This could include purchasing raw materials.
Cash flow statement line items
Net cash flow from operating activities
Operating activities include the production.
Capital expenditure
Any buying or selling of fixed assets which allow the running of the company to take place.
Other income
These include interest received on loans. and shipping the product.
Investment in financial assets
This is profit gained from investing in an asset which does not have a physical worth. such as stocks. bonds. payment to employees etc. such as land and machinery.
Non-cash items
These include depreciation. sales and delivery of the company's product as well as collecting payment from its customers. and bank deposits.
Disposals of property. etc. deferred taxes. which are added back to /subtracted from the net income figure. plant & equipment
Any profits or losses occurred from discarding concrete material of the companies. Changes can also result from the amounts spent on investment into capital assets. amortisation.

Dividends paid to equity shareholders
The distribution of the portion of a company’s earnings to their equity shareholders. Takes into account D&A.
Increase in new borrowings
An increase in the new borrowings issued by a company. Proceeds can thus be obtained if the price set by the option initially is less than the current stock price. Following the company share repurchase. A number of restrictions and conditions must be met for this to occur.
Proceeds from exercise of share options
The exercise of share options is the purchasing of an issuer’s common stock at the price set by the option. This is another profit multiple. which are the amounts that accrue periodically on an account that can be paid out eventually to the account holder. the shares are treated as cancelled.
This section was prepared by Uktarsh Majmudar and Ruzbeh Bodhanwala.
Reduction of borrowings
When a company reduces its debt by decreasing borrowings. and may help in judging what EV/IC is reasonable. The company must pay for the shares out of distributable profits or out of the proceeds of a fresh share issue to finance the purchase. payable to the company.
Purchase of own shares
This occurs when a company purchases its own shares. and can be used as a substitute for EV/EBIT. This is an unlevered price-to-book ratio.EMEA Equity Research Multi-sector September 2010
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Net cash flow from financing activities
This reports the change in a company’s cash position resulting from raising or repayment of financial liabilities.
Further multiples
Multiple Calculation Definition/Interpretation
EV/EBIT EV/NOPLAT EV/IC ROIC/WACC
EV EBIT EV NOPLAT EV IC ROIC WACC
Can be used to value a company. HSBC EDP (India) Private Ltd
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. Dividing ROIC by WACC helps to compare returns between markets (or companies) with different WACC. Takes into account tax. regardless of its capital structure.
Cash interest payable
The cash interests. regardless of the price of the stock at the time the option is exercised.
Issue of equity shares
Companies raise capital by issuing new shares either in the initial market (first time equity issue) or in secondary market (subsequent issues of equity). Global Research – Best Practise.

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Notes
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Notwithstanding this. if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage. In addition. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www. HSBC has assigned ratings for its long-term investment opportunities as described below. The performance horizon is 12 months. Stocks between these bands are classified as Neutral.
Rating definitions for long-term investment opportunities
Stock ratings
HSBC assigns ratings to its stocks in this sector on the following basis: For each stock we set a required rate of return calculated from the risk free rate for that stock's domestic. Details of these short-term investment opportunities can be found under the Reports section of this website. is or will be directly or indirectly related to the specific recommendation(s) or view(s) contained therein. regional market and the relevant equity risk premium established by our strategy team. the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). investors should carefully read the entire research report and should not infer its contents from the rating. In any case. or as appropriate. change of volatility status or change in price target). and 2) from time to time to identify short-term investment opportunities that are derived from fundamental.
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. quantitative. expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change. which depend largely on individual circumstances such as the investor's existing holdings. technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating.EMEA Equity Research Multi-sector September 2010
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Disclosure appendix
Analyst Certification
Each analyst whose name appears as author of an individual chapter or individual chapters of this report certifies that the views about the subject security(ies) or issuer(s) or any other views or forecasts expressed in the chapter(s) of which (s)he is author accurately reflect his/her personal views and that no part of his/her compensation was. and although ratings are subject to ongoing management review. However. This report addresses only the long-term investment opportunities of the companies referred to in the report. *A stock will be classified as volatile if its historical volatility has exceeded 40%. For a stock to be classified as Overweight.hsbcnet. ratings should not be used or relied on in isolation as investment advice. HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's existing holdings and other considerations. the implied return must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*).com/research. HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon. For a stock to be classified as Underweight. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. risk tolerance and other considerations.
Important disclosures
Stock ratings and basis for financial analysis
HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions. because research reports contain more complete information concerning the analysts' views. Investors should carefully read the definitions of the ratings used in each research report. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Given these differences.

Rating distribution for long-term investment opportunities
As of 13 September 2010. All market data included in this report are dated as at close 26 August 2010. however. please see the most recently published report on that company available at www.5 percentage points past the 40% benchmark in either direction for a stock's status to change.
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. unless otherwise indicated in the report. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. the distribution of all ratings published is as follows: Overweight (Buy) 51% (21% of these provided with Investment Banking Services) Neutral (Hold) Underweight (Sell) 36% 13% (18% of these provided with Investment Banking Services) (18% of these provided with Investment Banking Services)
Analysts. In order to avoid misleadingly frequent changes in rating. For disclosures in respect of any company mentioned in this report.com/research.hsbcnet. volatility has to move 2. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner. economists.EMEA Equity Research Multi-sector September 2010
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stocks which we do not consider volatile may in fact also behave in such a way. * HSBC Legal Entities are listed in the Disclaimer below.
Additional disclosures
1 2 3 This report is dated as at 14 September 2010.

may@hsbcib.David May* Head of Equity Research. Prior to his current role within research marketing he gained experience in both foreign exchange and interest rate derivative product areas. EMEA HSBC Bank Plc +44 20 7991 5353 nicholas. He joined HSBC in August 2009.com Nicholas joined HSBC in 2006.
Tim Hammett* Head of Research Marketing.
. and is not registered/qualified pursuant to FINRA regulations. a role he has been in since August 2007. EMEA HSBC Bank Plc +44 20 7991 6781 david.peal@hsbcib. EMEA HSBC Bank Plc +44 20 7991 1339 tim.com David May is Head of Equity Research. David worked in an Equity Sales role and an Equity Product Management role at a major American investment bank.
*Employed by a non-US affiliate of HSBC Securities (USA) Inc.com Tim Hammett is Head of Research Marketing for EMEA.
Nicholas Peal* Research Marketing. Prior to HSBC.hammett@hsbcib. EMEA (Europe and CEEMEA regions) at HSBC. He was previously Global Head of Equity Product Management at HSBC. bringing seven years experience of research marketing and knowledge management with a major American investment bank and a previous 13 years of equity fund management experience.